"Sarasota, Florida, guests of Sarasota trailer park picnicking at the beach"
Stoneleigh: People occasionally comment that we only consider the circumstances of the relatively wealthy in articles like, for instance, our Lifeboat Primer. It is true that by no means everyone can achieve the ideal circumstance of holding no debt, having cash on hand and having some control over the essentials of their own existence, however there are many other important factors in play that may decide the balance of advantage.
It seems important to consider explicitly the plight of those lower down the financial food-chain. The decisions people have to make will depend critically on their personal circumstances. However unfair it may be, all of us face constraints grounded in where we find ourselves in life, and we do not all have the same options available to us. This may seem overwhelmingly to favour the currently better off, but this is not always the case by any means. There are different ways of being well off besides the conventional monetary definition.
If one is going to fall out of a window, how much it hurts when one hits the ground will depend on how many stories high the window was. Some of those who live a relatively hand to mouth existence may find themselves falling out of a ground floor window. They will dust themselves off and move on. This will be much less painful than falling from the hundredth floor, as many of the better off will end up doing. People who may have nothing, but also owe nothing, are not so badly off in comparison with those who have a lot, but owe far more than they have. The latter is a very common situation, and will become increasingly common as assets prices fall in a deflationary environment, and debt servicing becomes ever more onerous. Very many seemingly wealthy people are over-stretched "like butter spread over too much bread", as Bilbo put it in The Lord of the Rings. Essentially, it is far better to have nothing, than less than nothing in net monetary terms.
As we have pointed out before (see Trickles, Floods and the Escalating Consequences of Debt), indebtedness can have serious consequences. Just because we have not seen these recently in developed countries does not mean they are gone forever (in an ever-increasing spiral of civilized behaviour). For the time being, civilized methods exist for getting out from under unrepayable debt, but these are unlikely to persist once too many people try to rely on them. For those who think they may need to have recourse to bankruptcy, it would be better not to wait too long, as that particular door may close. Being in debt gives others power over one's life, and that power may be exerted in many different ways, none of which are likely to be pleasant for the debtor.
We have seen the subprime crisis, which involved primarily the poor in an exploitative and predatory relationship with the financial system. That is now essentially over. The interest rate adjustments on those negative amortization loans (where borrowers were offered a low teaser interest which reset after a few years, and the unpaid interest was added to the principle at the end of that time) are mostly in the past. Loan re-adjustments will continue until 2012, but now for prime mortgages. These are typically people who are much wealthier, but couldn't resist, for instance, the Palm Springs beach house or the New York condo. These are people whose lives have always been thoroughly embedded in in our modern bubble economy, and whose decisions have all been based on the assumption of its continued existence. A significant percentage of such people is carrying many other forms of debt in addition to mortgages. Many wealthy people are in at least as deep a hole compared to their income as any subprime borrower, and many of them will lose their shirts as well.
Also, everything you own you may have to protect in one way or another, and this can require significant resources, as well as cause significant stress. Many wealthy people in disparate parts of the world effectively live in gilded prisons, where they have to pay for protection services (and never know when someone else may outbid them for the services of their private security guards). In some parts of the world, kidnapping the children of the wealthy approaches the level of national sport. While there are obvious comforts to being wealthy, it is no panacea and no real predictor of surviving or thriving.
The critical factor is not so much available money, as adaptability. Although money represents unmade choices, and is therefore an advantage in one way, the ready availability of money has also made many people soft, and prone to take the path of least resistance. This has often lulled them into a false sense of security. Some people know how to be poor and others do not. Better yet, some know how to be both poor and happy. For some, poverty would be merely a frustration, and for others an insurmountable obstacle. The Future Belongs to the Adaptable, not necessarily to the currently wealthy. Wealthy people are too often dependent on a functioning system - a system they have learned well how to navigate and function within, but a system that is extremely brittle in its economic efficiency. Without that all-encompassing life-support system, they may not be able to function at all. During the Soviet collapse, the former pillars of community (most often middle-aged men) frequently drank themselves to death because they could not adapt to a new reality.
The wealthy may have deliberately chosen to buy themselves out of the need for 'messy' human entanglements and interdependencies in favour of maximizing autonomy, but this can be an acute vulnerability in hard times. Community matters far more than money. No man is an island, and pooling resources can do a lot to help a group of people get through a bottle-neck, even if none of them is wealthy. Time, skills, creativity and emotional support are at least as important to share as money in building a mutual support system. Doing so can greatly reduce the dependence on money to the benefit of all involved, given that money will be very scarce. Pooling resources across the generations can be particularly important, and represents the way the vast majority of humanity already lives, where top-down services and other external supports have never been available. Extended family is a tried-and-tested, and very robust, structure.
In difficult times, who you know, and how well you know them, matters at least as much as what you know, and the most important connections are not necessarily those with the wealthy or powerful. There is simply strength in numbers, especially where those numbers are based on relationships of trust, and a trust born of mutual interdependence can be far more common in the lower echelons of society where it has been more necessary, and may therefore have been more firmly established already. It is necessary to know whom to trust, and towards whom to maintain a healthy scepticism. The poor are often more adept at telling the difference.
As Dimitri Orlov said, Real Communities are Self-Organizing:
"The rich get to play, while other, less privileged parts of the population, such as the immigrants, the squatters and the homeless, the chronically unemployed or underemployed, the bums (the real ones, not the ones in government), simply don't have the same options. At the same time, their need for community is much greater, and so they spontaneously self-organize, network informally, and defend their interests as best they can. They all know that "a nail that sticks up gets hammered down" and so they don't advertise their efforts or make them official or explicit."
We need to learn from those who have lived a life where they have had to learn on their feet. It is not possible, nor indeed necessary, to avoid all difficult environments, but it is quite likely to be necessary to learn to operate within them, and this is not a subject taught in school. As TAE commenter Subgenius said recently:
"I also bought a LOT of unpleasant people drinks, etc. over the first few years. A few years in and a situation got very out of control and I found I had a small army backing me up, which saved me from a pretty nasty set of possibilities. Remember - neighbors are ALL. You don't have to LIKE them, but treat them with what THEY perceive as respect and they will look out for you. "
Finally, we can take comfort in the words of John Steinbeck, expressed by Ma Joad in The Grapes of Wrath:
"I ain’t never gonna be scared no more. I was, though. For a while it looked as though we was beat. Good and beat. Looked like we didn’t have nobody in the whole wide world but enemies. Like nobody was friendly no more. Made me feel kinda bad and scared too, like we was lost and nobody cared…. Rich fellas come up and they die, and their kids ain’t no good and they die out, but we keep on coming. We’re the people that live. They can’t wipe us out, they can’t lick us. We’ll go on forever, Pa, cos we’re the people."
The King of Bonds
by Jonathan R. Laing - Barron's
Celebrated bond-fund manager Jeffrey Gundlach has a healthy -- some might say overdeveloped -- ego.
In the course of several interviews at the Los Angeles headquarters of his new investment firm, DoubleLine Capital, Gundlach drops any number of boasts. He can do the Sunday New York Times crossword puzzle in a half-hour. On a good day, make it 20 minutes. Gundlach, 51 years old, was a top student at Dartmouth, where he majored in mathematics and philosophy before entering a high-powered Ph.D. program in mathematics at Yale. He left, claiming boredom, to become a rock drummer in L.A., before drifting into money management.
"Look, I have a gift, or some would say a curse, of being able to have stunning insight into the reality of markets and the economy," Gundlach says, dressed resplendently at this particular moment in a well-tailored Italian suit with matching green tie and pocket square. "I don't often know where my ideas come from. Maybe it's the fact that I'm obsessively regimented in my analysis, borderline autistic. But whether it's bond selection or asset allocation, we can do it better than just about anybody around."
It is easy to dismiss such swagger, but Gundlach has the performance record to back it up. At Trust Company of the West, where he worked for more than 20 years until he was fired in December 2009, his flagship $12 billion TCW Total Return Bond Fund (ticker: TGLMX) finished in the top 2% of all funds invested in intermediate-term bonds for the 10 years that ended just prior to his departure, according to Morningstar. It finished in the top 1% for the five years ended just before that watershed event.
Gundlach's legendary success has continued at DoubleLine, which he founded shortly after leaving TCW. His DoubleLine Total Return Bond Fund (DBLTX), with $4.5 billion of assets as of Jan. 31, outperformed every one of the 91 bond funds in the Morningstar intermediate-bond-fund universe in 2010, despite launching only in April. It notched a total return of 16.6%, compared with returns of 8.36% for the giant Pimco Total Return Fund (PTTAX), run by the redoubtable Bill Gross, and 10.74% for TCW Total Return Bond, now managed by Metropolitan West, an able fixed-income shop acquired by TCW to replace Gundlach and his team.
Gundlach's DoubleLine Core Fixed Income Fund (DBLFX), with assets of $112.8 million, is no slouch, either. It returned a total 7.5% from its June 1 launch through the end of December, nearly three times the performance of the Barclays U.S. Aggregate Index in the same stretch.
Even more extraordinary, Gundlach achieved this record by investing almost exclusively in his specialty, securities backed by home mortgages, during a decade when the mortgage-backed market underwent tectonic shifts, destroying many less able investors. First, plummeting mortgage rates led to waves of refinancings, forcing mortgage-backed holders to reinvest pre-payments at ever lower rates. Then came the housing bust in 2007, and a tsunami of foreclosures and mortgage defaults that continue to this day.
Gundlach, who had warned of a coming residential-mortgage debacle as early as 2006, including in the pages of Barron's, deftly rode out the storm by switching out of private-market securities and into government-guaranteed agency paper issued by the likes of Fannie Mae and Freddie Mac. More recently he has burnished his results by buying private mortgage debt at fire-sale prices of 60 to 70 cents on the dollar, reaping both rich yields and price appreciation.
Gundlach's performance has been "nothing short of tremendous," says Eric Jacobson, Morningstar's director of fixed-income research. "He has slaughtered the indexes during an extremely difficult time. The only cavil might be that Gundlach is far less diversified across fixed-income sectors than, say, a Bill Gross, who has a mandate to go virtually anywhere, from government bonds and investment-grade corporate debt to sovereign paper and high-yield. So some might argue that any comparison of Gundlach's performance to most other managers is somewhat apples to oranges."
That's baloney, Gundlach and his associates say, maintaining they can replicate most interest-rate and credit risk extant in the bond market in their specialized sector. Gundlach had responsibility for $65 billion of TCW's $110 billion of assets under management, and made many of the security selections and asset allocations in TCW funds invested in all fixed-income sectors. Some even had a mandate to invest in stocks.
Gundlach rarely is shy about offering his opinion on markets. Like most bond honchos, including Gross, a member of the Barron's Roundtable, he seldom likes stocks, which are, after all, bonds' primary rival for investment dollars. "Though I rarely go public with specifics on stocks, I think the Standard & Poor's 500, which is now over 1300, will hit 500 in the next couple of years," he says. "I usually couch my belief by saying merely that 2011 will be a tough year for equities."
Nor has he made a secret of his bearish views on the U.S. economy and the seemingly inexorable rise in government debt. But he sees little chance in the near term of a surge in inflation that would send Treasury-bond yields soaring. A jump in the yield on 10-year bonds to a range of 4% to 4.5% from a current 3.6% would cause economic growth to short-circuit, he says.
By the same token, a renewed slowdown in the economy would drive 10-year bond yields sharply lower, but not below 3%, unless a banking panic similar to last year's euro-zone crisis ensues. As for the U.S. housing market, Gundlach expects home prices to fall by another 10% to 15%.
Gundlach's views on different bond sectors probably deserve more attention than his other pronouncements. He foresees a major collapse in the municipal-bond market, beyond the declines to date, given the parlous condition of both state and local government finances. He is preparing, he says, by having established a joint venture with the Chicago financial firm RiverNorth. Among other things, it expects to scoop up closed-end municipal-bond funds in the next year or so when the predicted apocalypse arrives, driving fund prices down, he says, to as little as 40% of net asset value.
What makes the $2.7 trillion muni market particularly vulnerable, Gundlach says, is its weak psychological underpinnings. Many investors in municipals are wealthy individuals who buy the securities purely because of their tax advantages and have little knowledge of the fundamentals of the paper they own. They tend to be "all-in" investors, owning little else, and thus will be prone to panic, he figures, in the face of surging defaults.
"Look, I don't know whether the market will suffer $10 billion or $30 billion in defaults, but the actual amount doesn't matter, Gundlach says. "There will be a panic at the margin, and muni bonds from the highest-rated on down will plummet, in part because other sorts of investors tend not to step in."
One of Gundlach's biggest regrets is not having had the mandate to buy high-yield corporate bonds in his TCW fund. Thus, he was unable to take advantage of the succulent values available in the high-yield market in late 2008, at the depths of the global financial crisis. His DoubleLine total-return fund can invest up to a third of its assets in high-yield debt, although he is hanging back from that market now, concerned that prices have rallied too much.
Gundlach's cautious take on high-yield is the result of an aperçu or intuitive flash he had several weeks ago, that the yield spread between high-yield and government bonds should be calculated using the 20-year government bond, rather than the entire Treasury yield curve. That's because high-yield paper, though maturing sooner than 20-year bonds, shares similar price volatility. The current 300 basis-point, or three percentage-point, spread between yields in the high-yield market and on 20-year bonds is as narrow as it has been at any time in the latest credit cycle, he notes.
DoubleLine has been careful about quality. It still avoids pools of subprime debt and securities backed by high loan-to-value mortgages. It prefers borrowers with high credit ratings, which implies such homeowners have the ability, if not the desire, to refinance. Pre-payments in this environment can provide a windfall profit, as the fund gets paid 100 cents on the dollar for mortgages that cost, say, 60 cents.
DoubleLine also shies away from subordinated-debt tranches, which could be wiped out in restructurings, and pools with lots of smaller mortgages, as high fixed closing costs deter refinancings of such debt.
Gundlach claims to have the finest mortgage-securities team in the country. Nearly all its members left TCW out of loyalty to him after his firing. In the DoubleLine trading room, more than 30 traders, managers and analysts sit at trading pods, arrayed in rows in front of Gundlach and DoubleLine President Phil Barach, who preside over the noisy throng like a pair of prankish camp counselors. Trading decisions are made quickly, and the esprit de corps is palpable. Traders laugh and whoop it up when, during a recent CNBC interview, host David Faber proclaims Gundlach the best bond manager of the past decade. When the graphic under Gundlach's image elevates him to best bond manager on the planet, the cheering grows even louder.
DoubleLine's funds currently are hedged somewhat against a possible double dip in U.S. housing, which would hurt the firm's private-sector securities positions. Gundlach claims his market opinions are right about 70% of the time, but just in case, the Total Return fund has a substantial position in long-term Ginnie Mae securities and various pass-through government-guaranteed collateralized-mortgage obligations, or CMOs.
These alphabet-soup securities tend to trade like long-term government bonds, with prices rising and yields falling in bad economic times, and the reverse occurring as the economy strengthens. Likewise, they have little pre-payment risk, as lower home prices have snuffed out much of the equity that even creditworthy borrowers had.
TCW's firing of Gundlach made headlines, especially as he had become the face of the firm on television and in the press, with his canny calls on the housing market and a bullish call on the stock market at its March 2009 low. Behind the scenes, however, Gundlach apparently had alienated TCW's well-heeled founder and chairman, Robert Day.
Day had always been adept at finding and fostering talented traders, but had trouble keeping top managers due to disputes about ownership stakes in the firm. The tension reportedly grew after he and others sold their stake in TCW to the French bank Société Générale. In Day's estimation, managers such as Gundlach were sufficiently compensated. Gundlach was paid about $40 million in 2009.
Gundlach was said to be disparaging of the "suits" running the company, as well as TCW equity managers who had performed poorly since the dot-com bust in 2000. He was also considered contemptuous of TCW's absentee owners in Paris, who paid more than $1 billion to acquire control of the firm. The warrants SocGen subsequently handed out to Gundlach and other TCW employees were rendered worthless by revelations in early 2008 that a bank employee had lost $7 billion in unauthorized trading in stock-index instruments.
Most of all, TCW was worried, and with some reason, that Gundlach might be planning to leave the firm. Better to shoot him and toss him overboard first, as Day is reported to have said in a conference call to employees after the ouster.
Although TCW offered many employees in Gundlach's fixed-income group financial inducements to stay at the firm, some 40 people followed their boss out the door. An estimated $25 billion of TCW's assets also departed, notwithstanding the company's simultaneous acquisition of Metropolitan West Capital.
In addition, institutional investors who had agreed to put money in some $5 billion of mortgage-backed funds with hedge-fund-type fees reportedly sought to back out once Gundlach left. The U.S. government pulled out of a planned $4.4 billion Public-Private Investment Program, or P-PIP fund that Gundlach was supposed to have managed, saying TCW had violated the key-man provision of the investment agreement.
Five weeks after Gundlach's dismissal, TCW sued the manager, four subordinates and DoubleLine for allegedly stealing trade secrets, including client lists, transaction information and proprietary security-valuation systems. The suit also charged that a search of Gundlach's offices had turned up a trove of porn magazines, X-rated DVDs and sexual devices, as well as marijuana.
After the suit was filed, institutional clients stopped calling DoubleLine. Instead of getting $20 billion in funds for which it had been negotiating, the firm got less than a half-billion. "Institutional gatekeepers have no incentive to do business with money managers caught in legal controversy, no matter how good their performance has been," Gundlach says.
He charges TCW with employing "smear tactics…to destroy our business." As for "the sex tapes and such," he says, they represented "a closed chapter in my life."
TCW filed another suit in December that sought to close DoubleLine's mutual funds temporarily or glom the funds' investment returns. A California Superior Court Judge hearing both cases dismissed the key counts against the funds and fund trustees. TCW refiled the complaint two weeks ago, absent the charges that would have affected the fund operations.
The trial over the trade-secret charge is scheduled for July, and promises to be incendiary. While TCW claims more than $200 million in damages, Gundlach, in a counter-claim, seeks to recover up to $1.25 billion in future income that he claims his group was denied as a result of his dismissal. Court documents suggest charges of the "sex, lies and videotape" variety could fly in both directions.
Both TCW and DoubleLine have been losers as a result of the legal fracas, although TCW noted, in a statement to Barron's, that assets under management are growing again, and that the investment performance of the funds managed by MetWest personnel has been strong. For that matter, DoubleLine's net inflows have been strong in the past two months -- Gundlach says the firm now manages about $7.5 billion -- indicating the battle hasn't intimidated all investors.
The winner, however, is Jeffrey Gundlach, whose reputation as the king of bonds is growing by the day.
Gundlach: Stimulus spending is like heroin
by Steve Watkins - Business Courier
If you weren’t worried about the U.S. debt load before, you would be now if you heard Jeff Gundlach speak [recently]. Gundlach is a bond manager and is CEO, chief investment officer and co-founder of Los Angeles-based Double Line, which manages bond investments. He was the speaker at the monthly CFA Institute meeting at the Queen City Club downtown, and his message was clearly a downer.
For one, stimulus spending is driving the economic growth the nation is seeing, such as the fourth quarter’s 3.2 percent gain. That’s not a good situation. "An economy fueled by the stimulus is similar to a heroin addict on heroin," he said. "What happens when the heroin is pulled away?" That doesn’t make him sound too optimistic about the post-stimulus economy. He put it even more bluntly. "My point of view is that economic growth is phony right now," he said.
Social Security now looks like it’ll be in deficit forever, or at least until it goes bankrupt in 2037, Gundlach said. It previously was supposed to be in surplus until 2018 before heading south. A look at the U.S. debt clock will show you just how bad things are getting. Just don’t have a weak stomach when you click that link. Projections have it heading to $70 trillion, while the economy is stagnating at $14 trillion. Not a good recipe. He didn’t offer any simple fixes for any of this, probably because there are none. But he said the U.S. government must change soon.
One change: Get ready for higher taxes at some point. He said 8 percent of our national income goes to the top 0.1 percent of the population. In 1980, only about 1 percent went to that group, the same as in other countries such as Japan and the United Kingdom. It’s diverged since then. "That looks to me like a powerful cocktail for a tax increase," he said.
Job growth would help, too. But that doesn’t look good. Here’s a harsh statistic for you. Gundlach figures the actual unemployment rate, when you include the underemployed and those who have given up on looking for work, is around 24 percent.
All in a flap about America’s deficit
by Clive Crook - Financial Times
Washington is quarrelling its way to a government shutdown, but not to a remedy for its fiscal problems. The reason is simple. Despite the noise and fuss, few politicians in Washington care that much about cutting public borrowing. They care about other things far more, and it might take another financial calamity to change their minds.
They are working on that.
Barack Obama has explicitly said that he does not care about long-term public borrowing. Having no proposals to deal with the problem is now official White House policy. There is no other way to interpret the budget the president sent to Congress last week. Under this plan, the full-employment fiscal deficit hovers for a while at about 3 per cent of gross domestic product later this decade, then explodes under pressure of rising spending on Medicare and other entitlements.
Let us be fair about this. It is not as though the president actually opposes deficit reduction. His budget does include a temporary and very partial spending freeze at historically elevated levels. If Congress comes up with a plan, he says he will definitely think it over. But his overriding priority is re-election in 2012. This rules out taking the lead on budget discipline. Fiscal meltdown between now and the election is unlikely, he calculates – this is the crucial judgment – so why expose yourself now by proposing a higher retirement age, say, or higher taxes for all Americans?
Fiscal lassitude must look especially appealing to Mr Obama when he considers the antics of the Republican-controlled House of Representatives. There too, cutting long-term borrowing is the last thing on anybody’s mind.
Under the influence of the recent influx of small-government zealots, the Republican majority cares first about hacking indiscriminately at short-term non-entitlement spending (thus ignoring both the spending categories that matter and the still-fragile state of the economy), second about blocking tax increases of any kind under any circumstances, and third about getting Mr Obama out of the White House. Public borrowing is something they deplore, but not as much as big government, and not as much as taxes.
Improving things still further from the White House’s point of view, the Republican party is split. The newcomers are full of zeal and refusing to take direction from the leadership, which by comparison has started to look moderate. On Saturday, the House passed a bill to authorise public spending beyond March 4. John Boehner, the House Republican leader, was forced to adopt much deeper cuts for the rest of this fiscal year than he first proposed – knowing, like everyone else, that the Senate and the president will not go along.
The Grand Old Party’s small-government fanatics almost boast about their lack of judgment. Public spending is public spending: what more do you need to know? The House just voted to slash competitive grants to improve low-performing schools, previously backed by the Republican leadership. It has voted to deny higher funding to the Securities and Exchange Commission, so that its new responsibilities under the financial reform act cannot be properly discharged. Really, the better the purpose, the better it proves your small-government seriousness to defund it. Democrats are delighted.
To measure Washington’s insincerity on public borrowing, look at what is going on in the states. There, the fiscal crunch has already arrived, and painful decisions can no longer be postponed. It is unsurprising that many governors, Democratic and Republican alike, look so much more serious than the artistes in the District of Columbia. They have no choice. They have reached the limits of their borrowing capacity – and, to make it worse, they know that raising state taxes might cause labour and capital to emigrate.
Republican governors such as Chris Christie in New Jersey, Mitch Daniels in Indiana and Scott Walker in Wisconsin face the same immediate fiscal challenge as Democratic governors such as Jerry Brown in California and Andrew Cuomo in New York – and their responses are perforce much the same. They are squeezing services severely and confronting the public sector unions that have forced pay, benefits and other terms of service out of line with private sector equivalents.
These efforts are meeting resistance, to put it mildly. Public sector workers in Wisconsin began huge protests at the end of last week, drawing national attention. What is interesting, though, is that the governors have come to a cross-party consensus about the measures that are necessary, and up to a point see each other as allies. That helps them do their job. Also, the ones who have been most forthright in explaining the fiscal facts of life to their constituents – especially the splendidly in-your-face Mr Christie – are winning respect for it beyond their states.
A troubling thought for Mr Obama, maybe, but for the moment the farce in Washington serves his purposes. Let the House GOP get on with it, the president’s advisers are telling him: keep the spotlight on them, and watch swing voters flock back. If we are really lucky, thinks the White House, the new continuing resolution will fail (remember it must pass House and Senate, still controlled by Democrats, in the same form). The government will have to shut down, as it did in 1995, financial markets will go crazy and it will be the Republicans’ fault.
Avoiding a fiscal meltdown would be good for 2012 purposes. Having one that could be blamed on Republicans would be perfect.
What a way to run a country.
Moody’s forecasts 'distress' for US muni markets
by Aline van Duyn- Financial Times
Moody’s expects defaults and distress in the $3,000bn US municipal bond markets but does not anticipate a broad "crisis of confidence", says the credit rating agency’s chief executive. "There may be additional defaults in the municipal sector. There certainly is going to be distress in the municipal sector," said Raymond McDaniel, chairman and chief executive of Moody’s, in an interview. "But we differentiate that from a broad-based systemic problem."
Increased scrutiny of the municipal bond markets, in which US states, cities and other public sector borrowers raise money, takes place as investors take a broader look at risks in sectors once seen as "safe". The eurozone debt crisis emphasised that even government debts carry credit risks. Mr McDaniel said the emergence of credit problems in bond sectors "traditionally viewed as a safe haven" had potential for confidence problems – with effects for the broader system.
"Because market participants have generally viewed that [municipal debt] as a risk-free area, [the question is] whether an individual credit problem can create a broader confidence problem. That’s where the systemic implications come in and what we and others are trying to be alert to." Potential for systemic risks emerging from municipal markets could not be ruled out, he said. "We consider it very unlikely. We do not rule that out. There are many different types of credits in the municipal sector, with many different forms of support."
"Once market participants focus on that and have a more refined, more nuanced, understanding of the risks and the support features in the municipal sector, I think that acts as a discouragement to a more panicked reaction." Credit rating agencies – heavily criticised for assigning triple A credit ratings to hundreds of billions of dollars worth of securities backed by risky US mortgages – have sought to make ratings processes more transparent and more thorough.
"The clearer we can be with our analysis, the clearer we can be in communicating our thinking to the market, the less I think we will have a blind reaction that would indicate a crisis of confidence," Mr McDaniel said. The municipal debt market, with thousands of small issuers, is particularly opaque, not least because many entities report financial information with a long delay. An estimated two-thirds of municipal bonds are owned by individual investors, lured by tax incentives. Jitters about creditworthiness has led yields to rise and investors have pulled money out of mutual funds that buy municipal bonds
Writing 'Danger' in Ever-Larger Letters
by Jeff Sommer - New York Times
The stock market has been thrilling lately. Thanks to the marvel of the mobile Internet, I’ve been able to check my account balances throughout the day, just for the pleasure of watching them rise — which is probably a sign that something’s wrong. Investing isn’t a sport, after all. As Benjamin Graham, the father of value investing, put it years ago, "The investor’s chief problem — and even his worst enemy — is likely to be himself." Taking too much joy in a bull market can be just as dangerous as panicking mindlessly in a market fall.
In need of an antidote for my buoyant mood, I turned to a man whose outlook is as bleak as an ice storm — Robert Prechter, the veteran market strategist, who makes garden-variety bears look like pussycats. I last spoke to Mr. Prechter about six months ago, just before the Fourth of July weekend, and he predicted a market crash of monumental proportions — perhaps the biggest decline of the last 300 years. Within six years, he said, the economy would be mired in a great depression, shattering millions of lives and devastating anyone foolish enough to hold stocks.
So far, though, the market hasn’t fallen. It has climbed, delightfully so, for those of a bullish persuasion. As measured by the Standard & Poor’s 500-stock index, it has risen more than 30 percent since his gloomy pronouncement. Did the powerful rally surprise him? "It certainly did," he said. In a lengthy e-mail, however, he pointed out that he hadn’t said the big crash would take place overnight.
Does he still believe that the catastrophe is coming? Oh, yes, he said, adding that, if anything, the recent good news for investors has made the outlook over the next several years much worse. "The market," he said, "appears much more dangerous today than it was last summer."
Mr. Prechter, based in Gainesville, Ga., is a social theorist and technical market analyst with a very unconventional approach. It is based on his own version of the Elliott Wave Theory, which originated in the writings of Ralph Nelson Elliott, an accountant who found repetitive patterns, or "fractals," in the stock market of the 1930s and 40s. The market still moves in cycles, large and small, Mr. Prechter says, based mainly on "social mood," which, in turn, influences the economy.
The current cycle will lead the unwary to ruin, he says, "We are in a long-term bear market that started in 2000." He says the rally that has been so enjoyable for stock investors is just a mini-cycle in that longer swoon. "I think the bear market will end when most debtors default and the media change from calling it a great recession that’s over to calling it a great depression that isn’t," he says.
Part of his argument will be familiar to anyone who follows the financial news. We are living "in a world saturated with debt," he says. "Newly conservative regulatory policies have been clamping down on bank credit," he adds. "State and local governments will soon cut spending and borrowing, and when the federal government finally cuts spending and borrowing and the Fed — either from within or without — is forced to stop" its quantitative easing program, the game will be up.
Of course, his picture of the world differs markedly from those of mainstream market analysts. For example, I chatted on the phone last week with Tad Rivelle, the chief investment officer for fixed-income at TCW in Los Angeles, who also says he sees trouble coming in the Treasury market. The Federal Reserve’s unorthodox monetary policy — the near-zero short-term rates and the large-scale purchases of Treasury securities in the Fed’s quantitative easing program — will need to be unwound, leading to a spike in yields over the next year and a half, he said.
But he took a measured view. Whether rising yields have a severe impact on the economy will depend largely on government fiscal policy, Mr. Rivelle said. "If policy makers in Washington do what they need to," and make credible cuts in the budget deficit, he said, the economy can have a "slow moderate recovery over the course of a very long time."
Similarly, James W. Paulsen, the chief investment strategist at Wells Capital Management in Minneapolis, also focused on the Fed. "The key investment question over the next two years is whether the Fed’s policy will lead to excessive inflation," he said. He also said that "we will probably have a market correction at some point this year." But he remains relatively sanguine. It is likely, he says, that inflation will be moderate, and that the overall trend for the economy and the stock market will be quite positive.
Mr. Prechter proudly marches to a different drummer. He says he is sorry that people who have listened to his advice over the last six months have had to watch from the sidelines while others prosper. "Being bearish in recent months was wrong, but I think it was prudent," he says. Danger is lurking, he warns, and not just in stocks, but also in bonds and commodities and other asset classes. "I have no interest in investing in any traditional financial market," he says. "They are all dangerously over-owned, overpriced and overleveraged."
If you do hold stocks, this isn’t the time to just sit back and watch your account balances rise, he says. "I believe deeply that opting for maximum safety is the right thing to do," he says. "I think bulls are about to lead people over a cliff."
Spain’s Cajas Have 100 Billion Euros of ‘Problematic’ Assets
by Emma Ross-Thomas - Bloomberg
The total exposure of Spanish savings banks to real estate and building amounts to 217 billion euros ($297 billion), of which 100 billion euros is "potentially problematic," the Bank of Spain said today. Bank of Spain Governor Miguel Angel Fernandez Ordonez, speaking in Madrid, said provisions cover 38 percent of the assets at risk. He also said the decree tightening capital requirements for cajas was "absolutely necessary."
Ordonez, who hasn’t spoken to reporters publicly since Dec. 13 when he said the state-run FROB rescue fund probably wouldn’t need to be tapped in 2011, described the fund as a "backstop" and a "guarantee" that all lenders will reach new capital requirements.
Spain’s government approved new capital requirements for lenders on Feb. 18 and set deadlines for lenders to meet the new rules or risk partial nationalization. The Bank of Spain is due to tell banks on March 10 how much additional capital they need and lenders planning initial public offerings have as long as a year to raise it.
Spanish Finance Minister Elena Salgado said on Jan. 24 the total capital requirements wouldn’t exceed 20 billion euros, and "all or part" of that would come from private investors.
Banking: The debt net
by Jennifer Hughes and Brooke Masters - Financial Times
When Ireland’s High Court issued two rulings this month, the initial response was muted. The so-called direction orders were formalities that began the wind-up of Anglo Irish Bank and Irish Nationwide Building Society, the two failed banks at the centre of the country’s financial meltdown.
Then, a few days later, there was a response to the court action – one that goes to the heart of the crisis in the eurozone and the question of just who should bear the cost of the bust. Two of Anglo Irish’s bondholders, Cayman Islands-registered hedge funds run by Fir Tree Capital, filed a lawsuit in a New York district court claiming the Irish rulings were "egregious" and "brazenly violate[d]" its right to be repaid.
Fir Tree’s claim to victim status contrasts sharply with attitudes in Dublin, where calls to "burn" the bondholders of Irish banks are a central theme in the general election campaign – itself a result of the crisis that toppled the government – that reaches its conclusion this Friday. Voters facing swingeing cuts, tax rises and job losses are angry. While such fury may be at its harshest in Ireland, it reflects a question being asked by many across the western world: why the investors who imprudently lent the money with which banks such as Anglo Irish made bad loans during the boom years now appear to be getting off scot-free, leaving taxpayers to foot the bill.
To date, bondholders have been largely shielded from the fallout of the eurozone crisis. Bonds – a form of debt – rank higher than equity, meaning that when business turns sour bondholders have a stronger claim to getting their money back than shareholders. While "junior" bondholders are expected to take losses – in Ireland, these second-tier investors have received as little as 20 per cent of their money – a far larger group of senior bondholders have not, so far. That is a state of affairs policymakers in Europe and the US are keen to change. In future, bond investors would lose part of their investment to, in regulatory parlance, "bail in" an ailing institution before taxpayers are called upon to bail it out.
The European Commission last month proposed a bail-in regime across the 27-member bloc. "We must put in place a system that is well prepared to deal with bank failures in an orderly manner – without taxpayers being called on again to pay the costs," said Michel Barnier, the European Union’s internal market commissioner, at the time.
The US has already put in place bail-in-like powers as part of the Dodd-Frank financial reform act passed last year. The law includes a resolution scheme that gives regulators the ability to impose losses on bondholders while ensuring the critical parts of the bank can keep running. Employees will be paid, the lights will stay on and derivatives contracts will not have to be instantly unwound, one of the areas that caused market confusion when Lehman Brothers collapsed in September 2008.
Germany and the UK have developed their own versions of bail-in. This month Denmark deployed its powers for the first time on the tiny Amagerbanken, after loan losses unexpectedly wiped out its capital. Creditors stand to lose two-fifths of their investments. Advocates of such measures see them as one way of sharing the pain and protecting taxpayers from footing the entire bill of future bank rescues. By quickly addressing the problems of sickly institutions, they would also help stabilise the financial system by removing uncertainty.
But bondholders and many bank executives warn that such moves could have negative consequences for the wider economy. Banks finance most of their customer lending through bonds. Raise the risks of bond investors losing money, and they will charge more in interest. If banks’ borrowing costs rise, that in turn will be priced into the costs of mortgages and other customer loans. Regulatory efforts to protect taxpayers could unintentionally expose them to a permanent rise in the cost of credit.
"[Bail-in] appears to be a self-serving cure to the financial community by the financial community, but in fact [it] contains the ingredients of causing greater harm to the broader economic world: the investment banks will shift the cost," says Tom O’Riordan of Paul Hastings, a global law firm. Furthermore, senior bank bonds are typically held not by hedge funds but by pension funds, insurers and other asset managers – the plodding pedestrians of the investment universe – attracted by the apparent safety and reliability of bank bonds. If that safety goes, there is a knock-on risk that the ultimate cost will be borne by those behind the insurers and pension funds: the general public.
Bail-in is a novel concept, which is one of the reasons it has caused such a stir. To start with, it is not an insolvency, a familiar process. When a bank or company goes bust, bondholders expect to lose money and take their place in the queue of creditors. What unnerves investors about bail-in is that it would take place in the no-man’s-land just before insolvency: a grey area where an institution is tottering but has not yet completely collapsed. Banks in particular need a special regime because they crumble so quickly. Traditional insolvency systems are too slow because cash and customers flood out of the door as soon as trouble strikes. "Insolvency is the third rail for banks. Touch that and everything starts to unravel," says Wilson Ervin, senior adviser at Credit Suisse. "So you deliberately design bail-in to happen five minutes before that."
As such, a bail-in is akin to an outpatient facility or an emergency room in a hospital – the patient is rushed in, patched up and sent out of the door again, albeit with life-altering injuries. Insolvency regimes, by contrast, have more in common with a long period of rehabilitation for a serious illness. But while this emergency treatment may save the patient, it will not come cheap. "Bondholders’ biggest fear is not getting repaid. With bail-in, that has to be a big risk and it will cost the banks," says one investor. "Bail-in should only ever be the very, very last resort but our fear is that regulators will do anything to prevent a failure and [impose losses] way too early."
According to a client survey by JPMorgan, a quarter of senior bondholders said they would not buy bonds that could be bailed-in. Analysts also calculated that responses to the survey implied bail-in would lead to banks paying on average an extra 0.87 of a percentage point for borrowing – a significant surcharge.
. . .
The timing of the debate is unfortunate. Markets have not fully recovered from the crisis; investor confidence remains fragile. While the biggest banks are able to sell bonds, smaller institutions and those from weaker economies such as Spain and Portugal are still struggling to tap the market at prices that make economic sense. Many of these weaker banks are still largely reliant on the European Central Bank for funding. In January the ECB privately warned the European Commission about the dangers of its bail-in announcement – even if it felt the long-term principle was sound – spooking the still jittery markets.
When Brussels unveiled its plans in early January, bond markets choked. For a few days they virtually froze as investors digested the implications. While nerves have since steadied, one outcome is already clear: investors are increasingly seeking specially protected bonds that would not be subject to bail-in. These include ultra-safe covered bonds backed by bank assets such as mortgages (see box). This year, banks are selling record amounts of them.
"Investors face uncertainty," says Fabio Lisanti, co-head of European debt capital markets at UBS. He says that "the pain is creeping up the capital structure", taking in instruments that were previously considered untouchable. "It’s hard for bondholders to make clear investment decisions in this environment," he concludes. Nervous investors tend to demand a further premium to cover the risks of the unknown. Rating agencies have already warned that the presence of bail-in is likely to lead to downgrades – another factor likely to push up borrowing costs.
Moody’s Investors Service last week downgraded the junior debt of five Danish banks and 23 German ones, and has warned that it is reconsidering its assessments of all banks’ junior debt in the light of bail-in regimes. There is also the question of whether bail-in would, in fact, help stabilise the broader system. Those inside the legal and insolvency worlds warn against thinking it could be a panacea whereby a weekend trip to the emergency room produces a once-again sprightly bank come Monday morning.
Tony Lomas, head of PwC’s insolvency practice, should know. The man heading the ongoing efforts to unwind Lehman’s sprawling European operations sees bail-in and other, related, powers that the EU is seeking as more akin to managing a terminal case by limiting the pain. "Bailing in a class of creditors is only a fraction of the answer, in terms of what you need to achieve market stability," he says. He lists other requirements, including a new legal framework to avoid triggering technical defaults on a bank’s dealings with its counterparties, substantial fresh liquidity and major operational changes to resolve quickly the problems that caused the institution to falter.
"Bail-in might allow you to freeze the institution, giving you some critical time to sell off or transfer the systemically important and viable pieces, but it’s highly unlikely to create an environment where you can preserve a bank in anything like its original form," adds Mr Lomas. The US experience bears him out when it comes to larger institutions. While the Federal Deposit Insurance Corporation, a bank regulator, has lots of experience of successfully shutting down small institutions, it has had far more trouble with bigger, more complex ones.
. . .
In Europe, lawyers have cautioned that altering existing insolvency regimes to reflect the new powers is no simple task since it touches on fundamental areas of law such as property rights. This is one of the arguments that Fir Tree has made in its complaint about the treatment of bondholders in Anglo Irish. It is a familiar position. Bondholders have none of the potential upside offered to shareholders, for whom theoretically the sky is the limit.
The best outcome that bond investors can expect is to receive their money and interest on time. This is why they have always guarded the legal covenants and conditions they felt guaranteed that they would be paid back in full. That now looks set to change. While challenges such as Fir Tree’s are likely to continue, bondholders face an increasingly united regulatory front on both sides of the Atlantic. "It is going to be the very rare case that the unsecured creditors are going to be paid in full," says one senior US regulator. "We are not going to make additional payments to long-term bondholders."
Who’s in the queue
- Depositors Bank savers protected partially by government guarantee in the event of insolvency
- Senior secured (or covered) debt Backed by a ringfenced pool of bank assets (say, mortgages) and an undertaking to make good on rotten loans – even in bankruptcy
- Senior debt Takes priority over junior debt and equity. Cheaper than both as it has strictest repayment terms
- Subordinated (or junior) debt Ranks below other debt. Terms may allow issuer to delay repayment, or skip or defer interest payments
- Equity Shares in the ownership of the company; first to take losses, therefore most expensive to issue
Sour Krauts and the EMU
by Ambrose Evans-Pritchard - Telegraph
Angela Merkel’s Christian Democrats have just suffered the worst defeat since World War Two in the Hamburg elections. Their vote share collapsed from 43pc to 21pc. A casualty of rising bread costs or Gefühlte Inflation as they say in Germany, perhaps, or bail-out rage? Merkel will lose another three seats in the Bundesrat, reducing her to a lame-duck Chancellor.
This greatly complicate chances of an EU deal next month to sort out the rescue fund, ie: To boost its firepower so that it is not caught with its pants down if trouble spreads beyond Portugal; to cut the penal interest rates on the Irish, Greek, (and Portuguese?) rescue packages so that these countries don’t suffocate to death. To allow the fund to buy the bonds pre-emptively to nip crises in the bud; to carry out a “soft-restructuring” by lending to Athens (or Dublin) so that it can buy back its own bonds cheaply on the open market.
Markets are not going to like it if Germany fails to deliver on the new “joined-up” package that has been flagged so widely in the press, usually sourced to Eurocrats in Brussels who do not have to face their own taxpayers, and officials from countries that might need a bail-out. As the ECB’s Athanasios Orphanides told the Wall Street Journal, the eurozone risks another investor panic if it does not get a grip soon. “The longer our political leadership delay in agreeing on a framework that will ensure stability, the greater the threat that we may have another crisis similar to what we experienced in 2010,” he said. Quite.
It is remarkable that this endless eurozone saga should still be going on amid robust global recovery (for now). But then EMU’s dysfunctional system is a remarkable beast, and has a remarkable ability to turn a largely successful and dynamic region into less than the sum of its the parts. We must watch Germany closely, and not just the eight judges of the Verfassungsgericht in Karlsrühe – that den of incurable Teutonism and closet eurosceptics.
The German economic elites seem more worried about inflation brewing at home than the ups and downs of Club Med bond yields, and these concerns will be even greater after the IFO confidence for February reached the highest since 1969. The PMI manufacturing index also surged to 62.6. It is a nice problem to have, but German economists looking one step ahead have good reason to be alarmed. As Jörg Kramer from Commerzbank said this morning, the ECB’s 1pc rate (and limitless support for EU banks) is “much too expansionary for a fast-growing Germany”.
Germany is at last becoming a victim of EMU’s one-size-fits-all interest rate. Join the club. It risks doing to them – though to a lesser degree, obviously – what it did to Ireland and Spain during the bubble when real rates (for them) were minus 1pc, minus 2pc, or minus 3pc, for year after year, with calamitous results. Hard-working and unsuspecting Germans are about discover what it feels like to be mugged by the EMU project.
A reader sent me this link from Focus, for those who understand German. It is warning by the HWWI Institute in Hamburg that German inflation may reach 4pc by 2012 and stay high for several years. “It is very difficult to get it back,” said chief economist, Thomas Straubhaar.”The effect works like an extra tax, a sort of property tax by the back door.”
They are certainly not going to “get it back” after the Auto Da Fe of Bundesbank chief Axel Weber, immolated for hawkish views. Others have taken over the ECB, and Germans they ain’t. For those of us who lived through the ERM crisis of 1992 and followed German events closely at that time, all this has a familiar ring.
It was not just recession in the UK, Italy, Spain, and parts of Scandinavia that caused the fixed exchange system to blow up, it was the deadly cocktail of slumps and banking troubles in these countries combining with German overheating. The mix triggered the final crisis. Like today, Germany was at a different stage of the cycle from others in 1992.
And like today, Germany was hit by an asymmetric shock that made matters worse. On that occasion it was the Fall of the Berlin Wall and the reunification boom: this time it is explosive demand for German goods from the industrial revolutions of Asia – and as the IFO Institute argues, it also an internal German investment boom as surplus savings that once went to Club Med now stay at home.
Of course, EMU is a very different animal from the ERM. Solidarity is total, we are told. Germany will do whatever it takes to defend the euro and Europe, we are told. It will meekly accept its ECB-driven inflation for the greater good of Greece, Italy, Spain, Portugal, and Ireland, and for the brotherhood of man, of course, of course.
No problem then.
Bank run fears engulf South Korea savings bank industry
by Jung Jae-yoon, Lee Jung-yoon - Jonggang Daily
More than a thousand customers lined up in front of the Busan II Savings Bank located in Busan yesterday as soon as the nation’s financial regulator announced a six-month business suspension of Busan Savings Bank and its affiliate Daejeon Mutual Savings Bank.
The line formed by depositors extended about 100 meters (328 feet) from the door of Busan II Savings Bank. "You won’t be allowed to withdraw your money if you are just standing there without a queue ticket number," a bank employee told the crowd using a microphone.
Those without a ticket then headed to the automated teller machines to withdraw their money, but the machines quickly ran out of cash. "I’ve saved 40 million won ($35,810) over my whole life. That money was going to be used for my grandson’s marriage but I cannot trust these people [bank employees] saying that I am guaranteed to get my money back," said Cho So-young, 79.
Although the government guarantees deposits of up to 50 million won at savings banks, the number of customers who hold deposits of more than 50 million won stood at around 4,700 in Busan Savings Bank and 675 in Daejeon Mutual Savings Bank, which triggered the current crisis. Although operations of three of Busan Savings Bank’s four affiliates were not suspended, there are fears that they could be hit by a bank run on their deposits.
In the case of Busan II Savings Bank, its capital adequacy ratio stood at 6.0 percent as of the end of 2010, but its liabilities exceeded assets by 12.5 billion won. Two other affiliates, Jungang Busan Savings Bank and Jeonju Savings Bank, have capital adequacy ratios of 3.6 percent and 5.6 percent, respectively. But they are unlikely to avoid a suspension of business if a bank run occurs.
The financial regulator recommends that savings banks maintain a capital adequacy ratio above 5 percent. The FSC yesterday placed on a watch list five savings banks whose capital adequacy ratio fell below 5 percent, including Bohae Bank, Domin Bank, Woolee Savings Bank, Saenuri Savings Bank and Yes Savings Bank. Financial authorities expressed confidence that these five banks would not be suspended since they were undergoing management restructuring.
But analysts expressed concerns that public panic about savings banks could spread. "The fears of depositors are mounting, which could lead to bank runs at a number of savings banks, and it could eventually spread to the entire savings bank industry," said Jung Sung-tae, a researcher at LG Economic Institute. The financial regulator is preparing to take measures to counter this possibility.
The state-run Korea Finance Corporation and four commercial banks - Woori, Kookmin, Shinhan and Hana - have decided to inject 2 trillion won of emergency liquidity into the savings bank sector. In addition, the government has decided to extend the amount of loans that can be borrowed by the Korea Federation of Savings Banks to support savings banks from the current 600 billion won to 3 trillion won.
Financial authorities are currently working to establish a joint deposit insurance account as a safety net for other financial sectors to curb the spread of possible financial risks from the savings banks. Funds for a joint deposit insurance account would be collected by financial institutions. "A way to secure capital [for savings banks] is to establish a joint account holding fund amounting to 10 trillion won," explained Kim Seok-dong, FSC chairman. "This problem will be closely discussed with the National Assembly."
Congress, Obama brace for showdown as government shutdown looms
by Paul Kane - Washington Post
The prospect of a government shutdown appeared more possible Saturday after the House passed a budget measure in the pre-dawn hours that cuts $61 billion - and was immediately rejected by Senate Democrats and President Obama.
The House plan, which was approved on a party-line vote at 4:40 a.m. after five days of debate, eliminates dozens of programs and offices while slashing agency budgets by as much as 40 percent. Federal funding for AmeriCorps and PBS would cease. Hundreds of millions would be cut from border security, and tens of millions would be withheld from funding for the District of Columbia.
The debate over the size and scope of the government now moves to the Senate, where leaders have already said that the House plan cuts way too deep and that they are planning a far more modest proposal. But with the Senate out of session all next week, senators have left themselves just a few days to take up a bill before March 4, when the stop-gap measure that is currently funding the government expires.
Given the tight time frame, it's unlikely the two chambers can agree on a compromise. If they don't, the government will either shut down or congressional leaders will have to agree on another temporary measure, perhaps for as little as a couple of weeks. But even that could be difficult. House Speaker John A. Boehner (R-Ohio) has said he won't approve another extension unless it also includes significant cuts. And it's unclear whether the scores of Republican freshmen who were elected last fall on their promise to dramatically downsize the federal government will agree to any sort of deal, particularly after insisting on the deep cuts agreed to Saturday.
"Nobody really knows where this is going from here," said Rep. Mike Simpson (R-Idaho), who helped craft the $61 billion in cuts as a member of the Appropriations Committee. For Boehner, Saturday's vote marked an early political victory, allowing his party to honor a 2010 campaign pledge to trim spending to 2008 levels. "It's democracy in action," Boehner said in an impromptu, triumphal news conference off the House floor just past 9 p.m. Friday, when it was clear the bill would pass. "I'm proud of this vote," he added.
The bigger victors were the 87 Republican freshmen, whose dismissal of an earlier plan that would have cut about $35 billion led House leaders to quickly draw up the larger package of cuts.
Unshackled by Boehner's commitment to a freewheeling process, the freshmen dominated the floor Friday and Saturday morning in passing amendments that moved the legislation further to the right, limiting the Environmental Protection Agency's ability to enforce clean-air standards and defunding the Consumer Product Safety Commission's ability to create a database of injuries.
All of the Republican freshmen supported the final legislation, including a couple of dozen from Midwestern states whose capitals are under siege from public worker unions protesting proposed cuts at the state level. "We are committed to changing the status quo in Washington and restoring our fiscal stability," Rep. Tim Scott (R-S.C.), a leader of the 2010 class, said after the vote.
What Boehner gained in credibility with the freshmen, though, he lost in terms of bipartisan outreach. Democrats, happy to be allowed to have votes on dozens of their own amendments, still unanimously rejected the final legislation. The final vote was 235 to 189; Republicans alone favored dramatic spending cuts, and three GOP representatives - two of whom thought the cuts didn't go deep enough - joined 186 Democrats in opposing the bill.
In an effort to appear frugal in their own right, Senate Democrats say they plan to cut $41 billion. But that is based on Obama's 2011 budget proposal, which was never enacted. In real-world terms, Senate Majority Leader Harry M. Reid's budget would keep spending at current levels. House leaders used this same math to claim that their $61 billion in cuts was equivalent to $100 billion, the amount Republicans pledged in their campaigns last fall.
Either way the numbers are counted, the two sides remain more than $60 billion apart. "Democrats are demonstrating a good faith effort to reduce the deficit and prevent a government shutdown," Reid (D-Nev.) said in a statement Saturday. But Senate Minority Leader Mitch McConnell (R-Ky.) immediately rejected Reid's approach, saying cuts had to be made to deal with an annual federal deficit predicted to hit $1.6 trillion this year. "Americans have been clear: Freezing in place the current unsustainable spending levels is simply unacceptable," McConnell said.
If enacted as is, the GOP plan would eliminate numerous programs, including the Corporation for National and Community Service, which runs the AmeriCorps program, and it would terminate federal funding of the Corporation for Public Broadcasting. It would cut $600 million from border security and immigration programs. It would eliminate nearly $80 million for the District and slash funding for the cleanup of the Chesapeake Bay.
On Friday and Saturday, Republicans approved measures that would provide narrow savings but impose sharp policy prescriptions, including the abolition of any federal funding going to Planned Parenthood and the restriction of any funds going toward the implementation of Obama's health-care law. "They are so out of touch with reality, it's breathtaking," Sen. Barbara Boxer (D-Calif.), chairman of the environment committee, said in an interview Saturday, noting the $2 billion cut in the EPA's ability to monitor clean air. "The public would not stand for this in the light of day. If you want to repeal a law, let's introduce a bill to repeal the Clean Air Act and let's have at it."
This debate is the first of several showdowns between the House and Senate, which could culminate later this spring when the federal debt limit must be raised or else the government will begin defaulting on its loans. Republicans have said they won't extend the limit without major budgetary reforms. "It's going to be fascinating here over the next few weeks and months as we work our way through this," Boehner said. "But these are going to be the most important two, three, four months that we have seen in this town in decades. It's all one fight."
Some lawmakers are hopeful that McConnell's renewed friendship with the White House, particularly his former Senate colleague, Vice President Biden, could pave the way for a deal similar to the one struck in December that led to large bipartisan votes for a tax-cut package. Last week, while backing his House GOP colleagues, McConnell signaled a desire for another round of private talks similar to those that he and Biden held in December that led to the tax deal.
"Can I foresee a situation in which both sides have to bring votes to the table? Yes," said House Minority Leader Steny H. Hoyer (D-Md.). However, Hoyer quickly noted that the December deal came before the freshmen were sworn into the House. "It's different players, and the new crowd demonstrated to their leaders this week that they were focused first on their promises," he said, adding, "A lot of them don't know the ramifications in their own communities of what they're doing."
Boehner reveled Friday night in both the impending victory and the unusually open process that stretched through most of the week, allowing hundreds of amendments to be proposed and more than 100 of them to receive votes. He took a victory lap through the lobby off the chamber floor and engaged reporters in an unplanned 25-minute question-and-answer session, contending that the wide-open process produced a "real debate" that stood in stark contrast to "watching 20 years of leaders tighten down the process, tighten down the process, tighten down the process." "This is diving off the 50-foot diving board on your first dive," he said.
Shutdown fears raise hopes for US budget
by Stephanie Kirchgaessner and James Politi - Financial Times
Republican leaders in the House of Representatives are in the early stages of crafting a new short-term bill to fund the US government, congressional aides said, in a sign that they are open to a compromise that would avoid a shutdown of the federal government. On Saturday the House passed an aggressive budget measure for the rest of the fiscal year that includes $61bn in spending cuts, which has been criticised by Democrats and the White House as too draconian.
But only a few days later it has emerged that Republican party leaders are preparing a bill that would fund the government for a much shorter period, with fewer spending cuts. A spokeswoman for Eric Cantor, House majority leader, told the Financial Times on Monday that they would "begin working on a short-term measure with smart cuts and savings to keep the government operating". This could be the basis for budget negotiations to begin with the Obama administration and leaders of both parties in the Senate. However, the effort could face a backlash from conservative members and lawmakers backed by the Tea Party movement, who have pushed for larger spending cuts and may want their leaders to stick to a more hardline position.
If no deal is struck by March 4, the federal government would have to close all non-essential services. A compromise in Congress that would avert a potentially disastrous shutdown of the government could represent a victory for Barack Obama, president, and senior Republicans in the Congress, who are more wary of the political ramifications of a shutdown than their Tea Party-backed colleagues. The commonly held wisdom in Washington has been that Republicans have more to fear from a shutdown than their Democratic colleagues.
The stand-off between Republican speaker Newt Gingrich and then-president Bill Clinton in 1995 led to a backlash against Republicans, who were accused of overreaching, and boosted Mr Clinton. But Vin Weber, a former Republican congressman who was in government at the time, said Mr Obama could also be hurt by a shutdown because circumstances had changed, especially the perception that failing to cut the budget could lead to economic disaster. "I don’t think anybody benefits from a shutdown politically. They ought to figure out a way to avoid it, but it is not easy," Mr Weber said.
No individual may be more influential in avoiding a shutdown than Mitch McConnell, the veteran Republican leader in the Senate who understands, perhaps more than his colleagues in the House, that a shutdown could haunt Republicans. Mr Obama saw big gains in poll numbers the last time he was able to reach a deal with Republicans over tax cuts following November’s midterm elections.
On Monday, Senate Democrats were weighing how to craft their own bill. "We’re trying to think this through so we can make the most cuts in the smartest way possible," said one Democratic aide. The starting point for Senate Democrats is a freeze on current spending levels, but lawmakers still have a wide range of views on how far they should go in meeting Republican demands for cuts to avert a government shutdown.
A consensus may not form until next week, when Congress returns from its recess. "I expect we’ll make change to the House-passed bill, but I’m not sure where folks will come down until everyone is back," another Democratic aide said. Republicans in the Senate painted this as a sign of weakness. "That’s probably why they haven’t produced a bill yet – while talking about a shutdown," one Republican aide said.
Political Fight Over Unions Escalates
by Neil King Jr., Thomas M. Burton And Kris Maher - Wall Street Journal
The clash between Republicans and unions that caught fire in Wisconsin last week escalated Monday: Labor leaders planned to take their protests to dozens of other capitals and Democrats in a second state considered a walkout to stall bills that would limit union power.
The protests have ignited a wider national debate over the role of labor unions and who should shoulder sacrifices as states scramble to tackle yawning budget deficits. Governors in both political parties are looking for union concessions as they struggle to balance budgets. Some are pushing aggressively to curtail the power of unions to organize or collect dues. On Monday, thousands of steelworkers, autoworkers and other labor activists surrounded the Indiana state capitol to protest a bill before the legislature to dramatically weaken the clout of private-sector unions. This is in contrast to Wisconsin, where a newly elected Republican governor is in a standoff with public-sector unions and their allies.
In Ohio, union officials are expecting 5,000 or more protesters Tuesday at the state house, where a legislative panel is considering a Republican-backed bill that would restrict collective-bargaining rights for about 400,000 public employees. Republican Gov. John Kasich supports the bill, a spokesman said. In Indiana, a House committee on Monday approved legislation to change state law so that private-sector workers no longer would be required to pay dues or belong to a union that bargains on their behalf. Unions say this would erode union membership, and eventually their finances and political clout, if workers decided not to join or pay dues. Supporters say the change would make the state more competitive and attract employers.
Democratic representatives in Indiana caucused into the night Monday, discussing a possible walkout to deny Republicans a quorum. They plan to meet again Tuesday morning. Rep. David Niezgodski of South Bend said Monday night that some Democrats are considering a walkout, contending the majority "are waging a war on the middle class now, in a way we've never seen before." About 22 states, mostly across the South, have laws similar to the one before Indiana lawmakers. In Indiana currently, if a union bargains for a group of employees at a workplace, all workers covered by the contract must belong to the union.
Indiana's Republican Gov. Mitch Daniels has aggressively gone after the state's public-sector unions, taking away their collective-bargaining rights on his first day in office in 2005. He is also pushing the state legislature this session to weaken tenure protection for teachers. But he has opposed the right-to-work bill that is now stirring anger in Indianapolis, fearing it would distract from his main legislative priorities. The protests in Indiana were reminiscent of ones that have choked the Wisconsin capital over the past week as teachers, students and prison guards continue to oppose a bill to limit public-sector unions' collective-bargaining powers. Democratic lawmakers there fled the state last week to thwart a vote on the bill.
Republican and Democratic leaders and strategists appear to be relishing the broadening fight over labor unions, feeling it is energizing their core supporters and clarifying key differences between the two parties. Democrats claim the fight has injected fresh energy into the ranks of labor unions, which are a major supplier of campaign money and volunteers for Democratic candidates. Republicans say the showdowns show they are the ones willing to make tough decisions to cut government spending and take on entrenched powers.
The various clashes over union benefits and clout hold implications for the 2012 elections as they spread to Indiana, Ohio and other presidential swing states. Many of the potential GOP presidential candidates, including Minnesota's Tim Pawlenty and Alaska's Sarah Palin, have backed Wisconsin Gov. Scott Walker and criticized President Barack Obama for taking the side of the public-sector unions. The AFL-CIO has seized on the Wisconsin protests to energize labor activism across the country. Union organizers say they are planning rallies and protests in dozens of state capitals this week as they scramble to tap into a surge of anger over the Wisconsin bill.
Gerald McEntee, president of the American Federation of State, County and Municipal Employees, the nation's largest public-sector union, said the moves in various state capitals to target state employees were an explicit effort to undermine a key source of Democratic funds. "They know how much we spent in the last campaign," he said. "They're going to try and shoot us down."
The 1.6 million-member AFSCME last year tapped emergency accounts and took out loans as it poured more than $90 million into Democratic campaign efforts in the mid-term elections. Overall, unions put around $400 million into the 2008 campaign to help elect Mr. Obama and other Democrats. Officials from both parties agreed the Wisconsin fight was freighted with consequence. But some also acknowledge that it was unclear so far which side the public would back. "The country will stand behind us as long as Republicans stand for fiscal responsibility and continue to govern as we campaigned," said Reince Priebus, the newly elected chairman of the Republican National Committee and former head of the Wisconsin GOP.
Illinois Sen. Richard Durbin, the second-ranking Democrat in the Senate, said Gov. Walker's efforts to weaken the unions' collective-bargain rights left Democrats no choice but to fight back vigorously. "For myself and most Democrats, this represents a core value, one that goes back in our history to the New Deal," he said. But Mr. Durbin said it was still too early to know whether voters would rally to the Democrats' side. "Public opinion is still volatile at this point," he said. "Those on the center stripe are paying close attention to who is being fair here and who is doing the right thing."
Other Democrats were more openly cheered by the struggle. Former Wisconsin congressman David Obey said the fight "has energized progressive forces like nothing I have seen in a long time." For the White House, the state budget fights pose a quandary. The president wants to show support for the unions, but the White House is also eager to show he is ready to make tough decision to cut the federal debt. Mr. Obama leapt to the defense of the Wisconsin unions last week, saying Gov. Walker's attempts to weaken their collective-bargaining rights amounted to "an assault." But White House officials over the weekend continued to point out that the president understands the need for shared sacrifice as states worked to conquer deficits.
The White House is also eager to distance itself from the array of mobilization actions that the Democratic National Committee unleashed last week to bulk up the rallies in Wisconsin and other states. The national stakes for both political parties in Wisconsin itself are particularly high. Mr. Obama won the state by a wide margin in 2008, as every successful Democratic presidential candidate has since John F. Kennedy. But Wisconsin turned sharply to the right in last year's election. If the current budget battle redounds to the Republican's favor, that could weaken Mr. Obama's odds in the state next year, and even his chances for re-election.
Downgrades loom for US states
by Nicole Bullock - Financial Times
Cash-strapped US states and cities face the prospect of downgrades after Fitch Ratings changed the way it analyses their burgeoning pension bills.
In a report published on Thursday, Fitch warns the new approach could lead to “limited negative rating action”, particularly for local governments with big wage bills. The changes to the way it assesses pension liabilities come amid growing concern over the scale of municipal debt problems and the effect on state and city finances of generous, unfunded public sector pension schemes that will run for many years.
Sharp falls in equities and other risky assets during the financial crisis reduced the funding levels of nearly all these pension plans, increasing the pressure on states and local governments when they have even less cash because of dwindling tax revenues to make up the shortfall. Revenues have tumbled while spending has been rising. “The key questions are whether states and local governments are funding their pensions, how much it is taking up of their general fund and concern about the crowding out of spending for other needs,” said Laura Porter at Fitch.
The rating agency, which used data from 2009, said there was cause for near-term concern about “a number of” pension plans and pointed to the “considerable pressure that these obligations will place on many government budgets”. The greatest risk would come at the local level since labour-related costs were a higher percentage of local government budgets, Fitch said.
In Miami, Florida, a quarter of the city’s operating budget pays for pensions. Among states, Illinois stands out for setting aside 12 per cent of its budget for its chronically underfunded pension. In valuing pension liabilities in its credit analysis of states and local governments, the rating agency will now assume a return on assets of 7 per cent, lower than the average return of 8 per cent used by most pension plans. That translates to an increase in the average plan liability of 11 per cent.
Using the 7 per cent rate does not shift any plans from being adequately funded, which Fitch considers to be assets equal to 70 per cent of liabilities, to “weak”, or under 60 per cent. However, plans in Montana, Hawaii, Vermont and New Jersey are among those whose funding ratios fall under 60 per cent using Fitch’s assumptions. The Illinois State Employees Retirement System is the weakest at 37 per cent, compared with 44 per cent using its reported 8.5 per cent assumed rate of return.
A hypothetical 6 per cent assumption, however, would drag plans in Nevada, Massachusetts and Minnesota from adequately funded to weak ratios. For state-run plans that also cover local workers, Fitch said it is difficult to assess how much of the liability is the obligation of the local government because plans typically do not provide this breakdown. That can overstate states’ obligation and understate what local governments owe.
The world wonders: Can states go bankrupt?
by Matt Miller - The Deal
From Sacramento to Albany, state governments, whipsawed by financial calamities from falling tax revenue to rising pension costs, are grappling with multibillion-dollar deficits and yawning budget gaps. An air of crisis hangs over the states. Ratings agencies warn of downgrades. Bondholders fret over possible default. State officials, legislators and interest groups of all kinds debate what is necessary to salvage finances: spending cuts, layoffs and, yes, even tax increases.
Into this uncertain and volatile mix, add a once-unthinkable word when it came to states: "bankruptcy."
Led by Republicans Newt Gingrich and Jeb Bush, the call for legislation empowering states to declare bankruptcy and restructure debts and obligations is gaining volume, if not necessarily resonance. The debate over state insolvency rages, at least in policy circles. Talk, however, usually centers on what bankruptcy might accomplish: pare back public pensions, renegotiate union contracts, slash debt and deficits.
But the legal complexities and constitutional ambiguities inherent in such a law are rarely discussed. Neither are actual mechanisms for implementation. That's understandable. It's messy. State bankruptcy cuts to the heart of a federalist system, with fractured political powers, bifurcated courts and uncertain hierarchies. Can states legally go bankrupt? The question looks simple, the answer anything but. "It's a very close call," says Richard Levin, one of the drafters of the modern U.S. Bankruptcy Code in the '70s and now head of restructuring at Cravath, Swaine & Moore LLP. Levin quickly adds that constitutional considerations are only part of the equation: "Simply because Congress may do something doesn't mean it should."
Allowing states to go bust takes insolvency into uncharted legal and financial waters. Some advocates, such as University of Pennsylvania Law School professor David Skeel, say a state bankruptcy could be an extension of the federal code governing municipal insolvencies, known as Chapter 9. "I feel that what's been done with municipal bankruptcy ... provides a pretty clear road map for what a state bankruptcy law could do," he says.
Those critical of an extension of Chapter 9 believe a state bankruptcy law would put multiple strains on the constitutional line separating federal supremacy powers and states' rights. "I think it's a terrible idea," says University of Texas School of Law professor Jay Westbrook. "Constitutionally and otherwise, Chapter 9 can't really tell municipalities what to do, much less states." Westbrook says an extension would expose weaknesses of the process. "The essence of bankruptcy is balance between debtor and creditor. In Chapter 9, there's no balance. It's all debtor. If Chapter 9 works badly for a water district, how would it work for a sovereign member of the federation?"
In this kind of bankruptcy process, divisions of power would pit state against federal, and possibly one branch of state government against another. Here's an example: Say a state goes bankrupt and seeks reorganization. In court, the attorney general, as the state's chief legal officer, would negotiate on behalf of the state. The AG might put a plan forward and agree to conditions. However, the AG has no say over the legislature. And only a legislature can raise taxes. In some cases, it would require a state constitutional amendment to reduce pensions. Add to this a federal judge who would oversee the process. Under Chapter 9, the judge has no authority to dictate terms or implementation. And a state has sovereign immunity, which means the governor or legislature may simply refuse to go along with anything the judge rules or reject the reorganization plan itself.
That two prominent states' rights advocates such as Gingrich and Bush would push for a plan that might put the fate of a state in a federal courtroom shows just how jagged the fault lines can be. Much as they might want to gut the power of unions and public-sector pensions, those that adhere to original-intent jurisprudence can't be comfortable with this kind of congressionally mandated mechanism. As Westbrook jokingly says, "Anyone who would have suggested this in the Continental Congress would have been shot."
Not surprisingly, the issue of state bankruptcy is proving deeply divisive. "I don't think it's a good idea," says Levin. "Leaving aside what makes sense in a state bankruptcy statute and what constitutional limits are, I would argue that if a state were willing and able to use it, it would be willing to make the necessary changes outside of bankruptcy. Why wouldn't the state make the changes without getting a scarlet letter 'B' stamped on its map?"
In contrast, one of his fellow drafters of the 1978 Bankruptcy Code is an enthusiast. "I think a Chapter 9 structure can be extended to the states and probably should be," says Kenneth Klee, founding partner of the Los Angeles law firm Klee, Tuchin, Bogdanoff & Stern LLP and a professor at the UCLA School of Law. "It is not fair or reasonable to ask American taxpayers to underwrite the profligacy of certain states with a blank check."
Klee and Levin do agree that the issue of a statute to deal with insolvent states never came up when they drafted the Bankruptcy Code. "At the time, no one thought it would be necessary for a state to file for bankruptcy," says Klee, who as associate counsel to the Judiciary Committee in the U.S. House of Representatives, was a principal draftsman of sections of the code dealing with corporate and municipal bankruptcy. "Nobody thought about it," agrees Levin, also legal counsel to the committee. "It just wasn't an issue."
The possibility that a state could become insolvent has grown likelier since the financial crisis. But even as states sink into debt, remedies remain so politically supercharged that stasis remains the default. Raising taxes and clipping bondholders are taboo to the right, while the left rejects slashing payrolls, rejiggering retirement benefits and cutting pensions.
The only way to provide a clean and equitable start is through a bankruptcy mechanism, backers advocate. Tax hikes, bondholder liabilities, retirement benefits -- "none of these are popular to discuss. I think, as a matter of fairness, all those people should be brought to the table as part of a financial restructuring," says Klee, who would like to name this part of the code Chapter 17. (Skeel favors Chapter 8.) "It's very unpopular to talk about bankruptcy in states, but when you look at alternatives, I'm not sure there are meaningful ones that make sense."
Some states have already acted. The Illinois legislature early this year boosted corporate tax rates by almost half and individual tax rates by two-thirds. Many critics not only reject tax hikes in a fragile economy but question whether more taxes can solve a $15 billion state budget deficit and almost $80 billion in underfunded pension liabilities. Bankruptcy "isn't something we'd likely contemplate seriously," says Barbara Flynn Currie, a Democrat and the Illinois House majority leader. She makes two points: First, the debt level compared to gross state product is far less than comparable metrics in, say, Greece or Ireland. More importantly, a state bankruptcy would "so roil financial markets that it would be very destructive to our country's economy. ... It would so shake confidence in public investment, it would make it much harder for any state to sell bonds."
To better understand the tangle of legal and policy issues, a history lesson is in order. It's doubtful a state has ever gone bankrupt in the strict legal sense of the word. Many, however, were insolvent and defaulted on debt. After the Civil War, a section of the 14th Amendment banned former Confederacy states from repaying debt to those who underwrote the war. In the 1930s, Arkansas defaulted on its debts.
Perhaps the closest a state came to bankruptcy -- that's what it was called at the time -- was Indiana in the 1840s. Indiana plowed millions of dollars it didn't have into a rash of costly, corrupt, failed public-works projects: canals, turnpikes and railroads. The state couldn't pay its debts and defaulted in 1841. London creditors cut the debt in half twice over a five-year period and seized uncompleted projects. Alas, all of them ended up as muddy sinkholes, save the Wabash and Erie Canal.
Despite Indiana's bout with bankruptcy, the Great Depression is the touchstone for modern bankruptcy approach and legislation. But even then, in terms of public-sector insolvencies, the focus was on municipalities, not states. As tax revenue plunged, municipalities lost their ability to service debt. By 1934, over 2,000 municipalities had gone broke.
Before legislation was enacted to address the issue, bankrupt municipalities faced enormous legal hurdles to get their debt under control. Municipalities are considered entities of a state. Under the Constitution, while the federal government can impair the obligation of contracts, states can't. So municipalities had no legal mechanism to reduce debt and bind creditors. Even if most creditors agreed to a voluntary restructuring, one or two could force tax hikes to pay off their debt in full through court-ordered compulsion, called a writ of mandamus.
Urged by the Roosevelt administration, Congress in 1934 passed a law authorizing municipal bankruptcy, called Chapter IX. However, the Supreme Court judged the law unconstitutional two years later, ruling that it was an invasion of state sovereignty. Congress passed a similar law in 1937. By then, the court was more sympathetic, upholding the constitutionality of the legislation in the 1938 case United States v. Bekins.
That ruling remains the legal foundation of municipal bankruptcies. Skeel, Klee and some other scholars believe that if a state bankruptcy law conforms to the Bekins decision, it shouldn't run into constitutional issues. Critics aren't so sure.
Pretty much everyone sees Chapter 9 -- it traded Roman numerals for an Arabic number when the modern code was promulgated -- and legal decisions surrounding it as the template for any states-related bankruptcy. Chapter IX and the updated version that followed gave insolvent municipalities powerful tools, including an automatic stay on debt repayments and the ability to bind all creditors to a plan. Perhaps the biggest legal benefit was the ability to get around the contracts clause by placing adjudication in a federal court.
Chapter IX remained in effect for almost 40 years. In 1975, New York City neared default, and the administration of then-President Gerald Ford rejected a federal bailout. So lawmakers wrestled with an updated legal mechanism that could accommodate muni bankruptcy and address issues such as union contracts. The result was a 1976 section of the code called Chapter 9. (It turned out New York City didn't file. Some believe that just the threat of bankruptcy was enough to get unions on board and to forge an out-of-court rescue plan.)
Two years later, when the Bankruptcy Code itself was revised, Chapter 9 was tweaked. According to Klee, the most significant change was a section delineating which provisions of the Bankruptcy Code would apply to Chapter 9 and which wouldn't. Some aspects of a Chapter 11 cramdown are incorporated in Chapter 9, but not all. Chapter 9 has a best-interest-for-creditors test, but it isn't the same as Chapter 11's.
Muni bankruptcies have since occurred rarely. Since Chapter IX took effect in 1937, only 620 municipalities have filed, according to James Spiotto, a Chicago-based partner at Chapman and Cutler LLP and municipal bankruptcy's unofficial scorekeeper. The vast majority of these have been tiny improvement districts that issue bonds to finance anything from sanitation systems to school buildings.
Orange County, Calif., was by far the biggest Chapter 9 in history. It filed in 1994 after a $1.7 billion investment pools loss. Since the crisis, the only city of any size to file is Vallejo, Calif., a suburb of San Francisco with 116,000 people. For more than a year, Harrisburg, Pa., has teetered on insolvency, largely because of a nearly $300 million garbage incinerator the city constructed on borrowed funds. A number of lawyers talk of a Chapter 9 filing, but the city has yet to act.
There are huge differences between Chapter 9 and Chapter 11, the part of the code that governs corporate reorganizations. One fundamental distinction: Municipalities can't be liquidated through an involuntary bankruptcy filing. As Marc Levinson, counsel to Vallejo, said last year, a city "can't go out of business."
Municipalities must voluntarily file for Chapter 9; creditors can't force them. After filing, a bankrupt municipality has the exclusive right to put forth a reorganization plan. Unlike Chapter 11, Chapter 9 has no absolute priority rule, which orders classes of debt and ensures that equity stakeholders get wiped out first. Municipal residents may be the equivalent of shareholders, but they aren't considered creditors under Chapter 9. So debt can be reduced without raising taxes first.
Because municipalities are considered instruments of the state, Congress requires state permission before filing. Klee says this was inserted as a nod to the state sovereignty issue. However, only 24 states have laws enabling this process. And even then, it isn't a sure thing. Late last year, the city of Hamtramck, Mich., sought permission to file for Chapter 9, only to have Gov. Jennifer Granholm nix the request.
A federal judge plays a very different role in a municipal bankruptcy from corporate reorganizations. Because of separation-of-powers issues, a judge has no authority over municipal operations and can't appoint a trustee or remove officials, no matter how neglectful or reckless they are. A judge can't order services to be cut or taxes raised. "Judges under Chapter 9 don't have a lot of authority. They're gatekeepers," says Omer Kimhi, a law professor at the University of Haifa in Israel. Kimhi, who wrote his doctoral thesis on Chapter 9, is very critical of its effectiveness. He differentiates between financial and economic difficulties. Corporations that file for Chapter 11 and have financial difficulties can reorganize successfully. Those that have economic problems liquidate. Municipalities tend to have economic woes. Yet, they can't liquidate.
In his view, restructured debt doesn't solve the underlying issues of most municipalities that have filed for Chapter 9. He cites the fact that many towns that file once and restructure end up filing again. Take Prichard, outside Mobile, Ala., a city of 25,000 that filed for Chapter 9 on Oct. 27, 2009, eight years after exiting a previous Chapter 9.
Despite Chapter 9's pronounced bias toward debtors' rights, municipalities still do everything in their power to avoid a filing. That's undoubtedly a function of fear -- from the bond market, from voters, from other municipalities worried about contagion. It's also an acknowledgement that a bankruptcy restructuring simply may not work in the long run.
All these aspects of Chapter 9 -- the voluntary nature of a filing, state sovereignty, the limited role of a judge, the inability to get mandated tax increases, the efficacy of a plan -- have critical implications for state bankruptcy laws.
This much everyone agrees on. A state would have to file for bankruptcy voluntarily, presumably with approval of both the governor and state legislature. A federal judge would have no more authority in a state bankruptcy than in a municipal one, possibly less. And then there's sovereignty, which may pose even more serious limits on state bankruptcies than municipal-related insolvencies.
A municipality is an organ of the state. A state is sovereign. That means a state can tell a bondholder it can't pay its obligations, and there's nothing a creditor can do. After all, states can't be sued unless they waive their sovereign rights.
At least that's the theory. But some legal scholars say it's not so simple when it comes to bankruptcy. Stephen Lubben, a professor at Seton Hall University School of Law, cites a 2006 Supreme Court decision, Central Virginia Community College v. Katz, as potentially critical in determining just how liability-free a state may be and what limitations to sovereignty there are. In that case, a bookstore went bankrupt and sued the community college for moneys owed. The college refused to pay, citing immunity against lawsuits under state sovereignty. A bankruptcy judge disagreed. The judge cited the so-called bankruptcy clause of the U.S. Constitution, Article 1, Section 8, Paragraph 4, which empowers Congress to make "uniform laws on the subject of bankruptcies throughout the United States." The judge said this provision trumps state sovereignty. In a 5-to-4 decision, the Supreme Court agreed.
Lubben posits a series of questions: What if a state refuses to pay a bondholder? The bondholder puts those assets in a limited liability company and declares bankruptcy. Could a federal bankruptcy judge order the state to pay what it owes as part of a bankruptcy proceeding? Would the state lose its sovereign immunity? Would the judge have enforcement powers? If it sounds like a constitutional mess, it probably is.
But sovereign immunity isn't the only legal twist that could upset the state-?federal equilibrium. Under the section of the Constitution that delineates powers, states are expressly prohibited from making laws that impair "the obligation of contracts." The only way around this, conventional thinking goes, is through use of the Constitution's supremacy clause, which says a federal law trumps a state one. So, in theory, a state could use the federal bankruptcy system to abrogate contracts, whether bonds or pension obligations, which it normally couldn't do.
Or can it? In 1974, the New Jersey and New York legislatures repealed a covenant of a 1962 bond series covering what would eventually become the Port Authority transport system. The U.S. Trust Co. of New York sued New Jersey. In 1977, the Supreme Court ruled that the state's repeal violated the contracts clause. Levin suggests this ruling could bedevil a voluntary state bankruptcy. "If the state voluntarily files for bankruptcy, who is impairing the obligation? Is it Congress or the state or the combination of the two? There is, of course, no precedent."
He goes on to ask questions about tensions between federal bankruptcy and the contracts clause: If a state "doesn't repudiate its obligations and simply doesn't pay, is the contract clause going to prevent that? If the contract clause would prevent that, then does bankruptcy power trump the contract clause? And does it trump it when the state itself is the actor in repudiating the obligation? It would be a constitutional thicket that Congress doesn't need to wander into for all the other policy reasons."
Of course, there are other practical issues involved in a state that abrogates its debt. As Illinois' Flynn Currie emphasizes, the bond market would go crazy. Kimhi talks about reputational costs of a muni bankruptcy, where access to bond markets by the municipality is at least temporarily shut down and where other cities find it difficult or costly to raise debt. A state filing could have an even more profound effect. It could affect bond ratings and the ability to borrow both for municipalities within the state and other states as well. Westbrook warns that a state bankruptcy might even harm U.S. Treasury bonds.
While critics maintain a state bankruptcy law, even if constitutional, is both ineffective and unnecessary, advocates say the mere threat of bankruptcy is conducive for renegotiating with interest groups such as unions. "If you didn't have a bankruptcy ultimatum, the unions could just say no,?" Skeel says.
That kind of clout should extend to bondholders, Skeel and others argue. It is possible to renegotiate with bondholders outside bankruptcy. But any renegotiation is voluntary. It doesn't bind everyone, and there could be holdouts. Intractable bondholders or the ones with the cleverest lawyers could end up extracting better terms.
Modifying pensions is even more problematic. Many state constitutions enshrine pension rights, requiring an amendment to alter those provisions. Could a court-supervised bankruptcy ease that? Advocates of a Chapter 9 extension believe so. Critics say not. "Nothing is more fundamental than the right of the people to have their own [state] constitution," says Westbrook.
Ultimately, for any state bankruptcy to work, there has to be consensus. Various branches of governments, interest groups and financiers must all congregate under some federal courtroom version of a big tent. They'd have to agree on a single vision, or at least enough of one to form a reorganization plan that various constituencies can accept. If not, a state bankruptcy would be little more than a time out. "You have to hope for a moment of clarity where everybody becomes of one mind," says Lubben. "That might be optimistic."
by Bill McConnell - The Deal
Municipal bonds aren't boring anymore. Long the refuge of conservative investors and retirees seeking steady, tax-free returns and a stable place to park their cash, muni and state debt is now viewed increasingly as a gamble. Cable news shows are full of speculation that Washington's next bailout will be to shore up the finances of deficit-racked states and cities struggling under ever-higher burdens of public pensions and Medicaid obligations.
Fears of defaults by state and local governments have been dogging the sector for more than two years, thanks to the bankruptcy of Vallejo, Calif., and the near insolvencies of Jefferson County, Ala., Harrisburg, Pa., and others. Then the market was cast into near panic in December when CBS' "60 Minutes" aired an interview with telegenic analyst Meredith Whitney. Famous for her bearish calls on banks, Whitney predicted there would be 50 to 100 sizable state and municipal defaults in the near future. The coming collapse, she said, will affect debt worth "hundreds of billions" of dollars and likely lead to immense pressure on Washington to bail out the burdened governments and their investors. Her comments sparked a monthlong muni selloff, with investors yanking $4 billion out of the market through mid-January. Stability has slowly returned, but wariness lingers.
While muni experts panned her prognostication as overly dire, the fact remains that state and city finances are a mess. And though defaults on local government debt have been rare, a handful of jurisdictions may have to make draconian moves to stay current on debt obligations. The menu includes service cuts and tax hikes. Nevertheless, it's wrong to paint the situation as an immediate crisis. Most current-year budget problems are being addressed with spending cuts and tax hikes. The longer-term fiscal wreck presented by pension and healthcare burdens can be addressed over the next decade. But, as is so often the case, lawmakers are hyping the situation to pursue initiatives that wouldn't get traction without the presence of a crisis.
Whitney's prediction certainly caught Washington's attention. At the same time, city and state officials were prowling congressional offices talking up various ways the federal government could help, with suggestions varying from new stimulus to relief on Medicaid and unemployment insurance. The new Republican majority in the House has seized on the issue, warning that financially profligate local and state officials are kidding themselves if they think their turn for a bailout has arrived. "The era of the bailout is over," Rep. Patrick McHenry, R-N.C., chairman of the House Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, said at a Feb. 9 hearing. The GOP has also used the issue to attack one of their chief targets -- public-sector unions, which they say have used collective-bargaining muscle to extract outsized wage, pension and health benefits from taxpayers, whose private-sector jobs often provide much less generous packages.
"It seems to me that public-sector and private-sector employees are living in two separate economies," McHenry said, arguing that public workers make on average $14 more per hour in wages and benefits than private counterparts. Some conservative pundits have called for outlawing public-employee collective-bargaining rights. Many also call for an end to defined-benefit pensions, an open-ended obligation companies began abandoning years ago.
On the same day as the hearing, Rep. Devin Nunes, R-Calif., and Sen. Richard Burr, R-N.C., introduced the Public Employee Pension Transparency Act. The bill would implement uniform reporting standards for public-employee pension funds but would not dictate how the pensions are funded. It would, however, bar a federal bailout of state and local government pensions. "It is time to open the books," Nunes said in a statement. "Once we enact this bill, retirees, government workers, policy makers, and most importantly the people who are paying the bills, can make up their own minds about the soundness of public pensions."
Potential Republican presidential candidate Newt Gingrich and former Florida Gov. Jeb Bush seized upon the uproar to call for letting states declare bankruptcy, an option already open to cities. The option excites them because it might allow states to break pension requirements. They complained that California alone will pay pensions of $100,000 or more this year to 12,000 former government workers.
David Skeel, corporate law professor at the University of Pennsylvania School of Law, told McHenry's subcommittee that allowing states to declare bankruptcy would allow them to restructure their obligations -- including pensions and bonds -- at the same time. "It brings everybody to the table. Not just one or two constituencies would be asked to sacrifice."
Democrats also appear determined, as the Washington cliché has it, not to let a crisis go to waste. Recognizing that a new round of stimulus or a direct handout to states is a political impossibility following the GOP's House takeover, President Obama on Feb. 14 proposed a slightly less direct approach. His budget would give employers an extra two years before higher unemployment compensation taxes kicked in. States also would get a two-year reprieve before they have to start repaying loans they took out to cover the added unemployment burden created by the downturn.
Amid the debate, there's no disagreement about the sorry conditions of states' books. Almost entirely because of the economic downturn, states are predicting operating deficits totaling $125 billion in 2012, according to the Center for Budget and Policy Priorities. Although revenues are slowly recovering from the downturn's nadir, they remain 12% below prerecession levels.
Longer term, states face pension shortfalls that vary from $1 trillion -- if you believe their forecasts -- to $3.5 trillion -- if you accept the numbers of more skeptical economists.
Whitney has painted the combination of operating deficits and pension underfunding as one that will inevitably lead to major defaults. But even muni debt analysts critical of the government do not predict the pension issue will come to a head in the next few years.
According to a study by Northwestern University associate professor Joshua Rauh, at least 31 states will eventually face pension shortfalls. Eight will run out of assets by 2020. Underfunding by Illinois is the most pressing issue. That state, Rauh predicts, will run out of pension assets in 2018, at which time it will have to kick in $11 billion annually to meet its obligations. That's hardly good news to Illinois taxpayers, whom Gov. Pat Quinn just hit with a 66% increase in state income taxes to cover the current gap in the operating budget. Rauh notes that Illinois' pension assumptions are overly optimistic. More conservative -- and in his view, reasonable -- assumptions bring the crisis to a head sooner, but still years away.
According to Rauh's study, New Jersey faces a similar situation: It will need $10 billion annually beginning in 2020. Ohio, which will require $13.8 billion beginning in 2031, is in the same boat.
To stabilize pensions, Rauh has recommended states be allowed to issue tax-subsidized pension funding bonds for the next 15 years if they implement specific pension reforms. To get the subsidy, states must agree to close defined-benefit plans to the 1 million new workers who take state jobs every year, and provide new hires defined-contribution plans similar to the federal Thrift Savings Program, as well as guaranteed access to Social Security. Only a quarter of public workers contribute to Social Security. Bringing them into the system would add a further $175 billion to the program, he says.
The cost for the pension security bonds would be about $250 billion. Incorporating the offsetting Social Security gain, he says the subsidy's final cost to the federal government would be $75 billion, far less than the $1 trillion minimum that would be needed to right the current local pension system.
The notion of switching new pensions from defined-benefit to defined-contribution plans is gaining traction among politicians. Guaranteed-benefit plans offer retirees a fixed paycheck regardless of how fund assets have performed or whether employers have fully funded them. Defined-contribution plans require employers to make annual payments to retirement funds, and the payout is based on how the funds performed over the workers' careers.
Nicole Gelinas, a fellow at the Manhattan Institute, told McHenry's committee that governments cannot break obligations to current workers but should restructure pensions for new employees. She favors defined-contribution plans. The federal government, however, should let states work out the restructuring on their own. "States already have tools to deal with these things themselves. States can change their laws that govern pensions. States can change their laws that govern contracts, healthcare benefits. They do not need to look for Congress to do it for them." She did say that the federal government could assist states by lessening Medicaid obligations.
Eileen Norcross, research fellow at George Mason University's Mercatus Center, told the committee that there is one thing Congress should do: Insist that states make more realistic assumptions about portfolio rates of return. Both contributions and benefit promises should be based on those numbers. On average, states have assumed they can make 8% annual returns year after year. Instead, she said, economists believe 4% is a more appropriate assumption.
"The circular logic of government pension accounting standards has had several consequences," Norcross said. "It has led to undervaluing of pension promises and the amount necessary to fund the promise. Politicians ... in the 1990s often boosted benefit formulas because plans were overvalued on paper. Plans have been encouraged to embrace more investment risk, including increasing their risk exposure after the recent market downturn to make up for losses."
Representatives of state and municipal employees say the attack on pensions is a canard. Steven Kreisberg, collective bargaining director for the American Federation of State, County and Municipal Employees, argues that the notion that government budgets are under stress because of pensions is "the biggest myth out there." He says, "State and local governments are spending 3% of their budgets on pensions. If you say that's what's going to drive state budgets off the cliff, I'm going to debate you."
By far the biggest expenditures are health and education for states and public safety for municipalities. Nearly all have made cuts in those areas since the recession. "States are spending less," he says. "It's not spending that's the problem; it's the recession."
The pension focus is really just a way to attack unions, Kreisberg says. He notes that the average government union worker makes just over $40,000 and will be entitled to a pension of roughly $19,000 a year. "We need to separate the political agenda from the real economics of pension plans. These are real people being hurt -- librarians, police officers and firemen. They're going after the wrong guys."
In states with dire pension shortfalls, Kreisberg says the culprit has been chronic underfunding. "New Jersey got into hot water after 17 years of neglect that began with Gov. Christine Todd Whitman. In Illinois there has been a 30-year history of underfunding."
The call for allowing state bankruptcy isn't a serious proposal, but simply "a political ploy" to divert attention from tax cuts Republicans want to enact. "They're trying to hype the notion that government is collapsing around us. Bankruptcy was never a serious policy proposal. No governor has wanted it." He notes that in municipalities where bankruptcy has been declared or seriously considered, the town's problems were caused not by pensions but by "misguided capital projects" such as Jefferson County's $3 billion water treatment plant.
What's more, he says, bankruptcy doesn't provide a legal avenue for addressing pensions. "Bankruptcy does not allow you to unwind pension obligations. They're long-term obligations and not a factor in immediate liquidity problems. What's going to happen in order to make pensions whole, bankrupt towns might have to lay people off."
Kreisberg criticizes Nunes' bill on transparency too. "These guys must have read a lot of George Orwell as kids. They would essentially be creating an accounting regime for pension plans that no one else uses. The plan would require states to value pensions as if they were to be terminated immediately."
Kreisberg has a more favorable view of a separate effort under way at the Government Accounting Standards Board to create uniform reporting standards. GASB is also examining actuarial assumptions for government contributions and promised benefits. Neither Norcross nor Gelinas would offer an opinion of GASB's plan until actuarial assumptions are presented.
"I think real trouble is brewing," says Valerie Roberts, Jones Day's head of the muni bond tax practice. "I don't think it's quite imminent, but the recent debate has been a good wake-up call. Many governmental pension funds currently claim they are well funded. However, I think many will find they are not if new GASB standards are adopted."
Iris Lav, senior adviser to the Center on Budget and Policy Priorities, agrees with Kreisberg that no federal actions need to be taken. "Most states are not in crisis," she says. "There's no need for federal intervention in this area."
States can -- and are -- dealing with short-term funding gaps caused by recession. She agrees that cuts to education and police and fire departments are painful. But they are necessary and for the most part being made.
She opposes lowering pensions' expected investment returns because it doesn't reflect the likely returns an appropriately mixed portfolio will provide. Longer-term shortfalls can be addressed by boosting state contributions. States contribute, on average, 3.8% of their budget to pensions. The gap could be closed, she says, by increasing that to a manageable 5%. Defaults will likely be limited to "some sewer districts and some revenue bonds," she says. "I don't think we're going to have a major default crisis."
Anger as Milan bourse fails to open
by Jeremy Grant in London and Rachel Sanderson - Financial Times
Borsa Italiana, the Italian exchange, failed to open as usual on Tuesday amid concerns in the Italian broking community about possible fallout from turmoil in Libya. The outage, which left brokers unable to process orders, came a day after the main Italian stock market index closed down 3.6 per cent, making it the worst performing European market on Monday.
Traders in London said the failure to open meant that the crucial opening auction, which sets initial prices at the Borsa, had also not taken place. Yet there was growing demand from investors to trade certain blue chip Italian stocks. A trading expert at one US bank said: "All of us are pretty worried. Because of the news around Libya and the need to trade certain stocks we do need to trade some stocks."
Borsa Italiana, part of the London Stock Exchange, said the cause of the outage was not known beyond the exchange’s initial diagnosis this morning of "a technical issue on the price information systems". Banks and brokers were forced to switch their electronic trading systems over to rival platforms where Italian stocks are also widely traded, mainly Chi-X Europe and BATS Europe. Trading on the Sedex covered warrants and certificates market, as well as its MOT bond trading platform was also hit.
Banks' Plea to Transfer Mortgage Risk Likely to Fail
by Floyd Norris - New York Times
When the mortgage securitization market collapsed amid a flood of defaults and foreclosures — many of them on loans that should not have been made — the cry arose for lenders to have "skin in the game." To properly align incentives, the argument went, those who make loans must suffer if the loan goes bad.
That principle was enacted by Congress last year in the Dodd-Frank law, but the mortgage industry managed to persuade legislators to insert an ill-defined loophole that would allow at least some mortgage loans — and perhaps nearly all of them — to escape the requirement that banks retain at least 5 percent of the risk. Now it is up to an unwieldy council of regulators to set the parameters of that loophole. They will do that by defining the term "qualified residential mortgage." If a loan is a Q.R.M., as bankers now refer to such loans, then it can be sold to investors without the lender retaining any risk.
Much of the banking industry has been pushing for an expansive definition that would leave few, if any, conventional loans subject to the skin-in-the-game requirement. To hear them tell it, there is virtually no way that any bank would make a mortgage loan at a reasonable rate if it had to share in any losses. "The potential impact on the availability of credit stemming from the Q.R.M. risk-retention exemption cannot be overestimated," John A. Courson, the president of the Mortgage Bankers Association, wrote in a letter to regulators.
"Few loans to ordinary customers are likely to be made outside the Q.R.M. construct; the loans that are made will be costlier and likely to be made only to more affluent customers." In other words, Congress did not know what it was doing when it mandated the retention of risk, and the regulators should spare us such folly.
If bankers had their way, only loans that were negatively amortizing, or had balloon payments, would be excluded. You could buy a house with no money down, so long as you took out mortgage insurance. Even interest-only loans would be acceptable in some instances, and what few rules there were could be circumvented because bankers would be given discretion when applying the rules.
It now appears the regulators will not go nearly that far. According to people knowledgeable about the discussions, the regulators are likely to propose that the definition allow only loans with a down payment of at least 20 percent. Adjustable-rate loans would be permitted, but there would be limits on how large an adjustment would be allowed. These people spoke on the condition that they not be named.
One provision likely to set off controversy is a limit on how that 20 percent down payment is obtained. The buyer would have to put up at least half of it — 10 percent of the purchase price — from his or her own holdings. The rest could be a gift, from parents, for instance, but it could not come from seller concessions or from borrowing. Mortgage insurance would not enable a nonqualifying loan to become qualifying.
The regulators hope the result of this will be two vibrant mortgage markets, with a substantial share of mortgages in each market. If a qualified mortgage is defined too broadly, there would be few other loans made, and even fewer of them would be able to be packaged in securities, when and if a private-label market for those securities begins to function again. Without enough available loans, no such market would be likely to develop.
The bankers’ solid front on the issue was shattered by Wells Fargo, which suggested that only loans with a 30 percent down payment — a 70 percent loan-to-value ratio — should qualify. Other bankers were horrified. In an interview, John P. Gibbons, an executive vice president of Wells Fargo Home Mortgage, said he thought "skin in the game" made sense and would make it more likely that private investors would again be willing to invest in mortgage securities that did not have a government guarantee. "You gain confidence when you go to a restaurant and see an owner is eating his own food," he said.
That was the view of Barney Frank, the Massachusetts congressman whose name is attached to the law. "We’re basically saying now, ‘You’ve got to keep 5 percent of that,’ " he said after the law was passed. "That way we’ll just get better-quality loans made in the future."
One reason some lenders oppose skin in the game is that they do not have enough capital to cushion the additional risk. Those not affiliated with depository institutions are not used to keeping loans on their books, and a requirement that they do so could reduce the amount of competition. That could help well-capitalized banks, like Wells Fargo, the largest mortgage lender in the country. According to Mortgage Daily, a trade publication, Wells Fargo had a 25 percent market share for mortgage loans made in 2010.
The group of regulators, which includes the Securities and Exchange Commission and bank regulatory agencies, as well as the agency that supervises Fannie Mae and Freddie Mac, must also decide just what constitutes "skin in the game." The law says banks should keep a 5 percent stake, but it does not say how that should be calculated.
It seems likely that the regulators will mandate some form of "vertical" share, meaning the lender would keep at least a 5 percent share of every tranche in the securitization. A "horizontal" share — in which the lender would suffer the first 5 percent of losses — has some advocates. But there are concerns that ways could be found to structure deals so that such a "loss" was illusory because it would come out of profits that were not expected to be earned in the first place.
The new rules will apply to all securitizations, including those guaranteed by Fannie Mae or Freddie Mac. If the Q.R.M. definition is as tight as now seems likely, that means banks would have to retain risk even on some loans guaranteed by those agencies.
The Federal Deposit Insurance Corporation, one of the regulators, has been pushing to include servicing standards in the Q.R.M. definition, and has gained some support, although no final decision has been made. Such standards would change the way banks are compensated for handling billing and receiving payments. They now get a fixed fee, but the change would pay them more when a loan is in trouble and requires more work.
Such a rule would also require that servicers be allowed to modify the principal balance or interest rate on outstanding loans if that would be beneficial to the securitization as a whole, even if such a decision would hurt one tranche relative to others.
The regulators are required to get a proposal out by April 17, and had been expected to act by now. One person involved says an announcement is likely soon, but refrained from being more specific. None of this is made any easier by the fact there seems to be nothing except peer pressure to force any regulator to accept a rule favored by the other regulators.
Once a proposal is released, it will be open for comment, and there is likely to be fierce lobbying. Many banks will take the position that excluding any loan from the definition of a Q.R.M. is tantamount to denying a mortgage to a borrower who needs such a loan, and will warn that restricting credit in that way could further devastate the housing market.
On that position, they may have some allies. A joint letter to regulators from groups of banks, home builders, real estate agents and consumer groups warns that "a Q.R.M. definition that is too narrow would prohibit many first-time homebuyers from buying a home, especially if the definition includes an excessively high minimum down payment requirement. That conclusion is based on the assumption that non-Q.R.M. loans will not be made, or at least not made at a reasonable cost. But it is far from clear that would be the case; Wells Fargo says it will make such loans.
In essence, pleas for a broad definition assume both that "skin in the game" is unreasonable and that it is unnecessary, because bankers can be trusted to never repeat the mistakes that got us into this mess. "We must also remember," Mr. Courson, the president of the mortgage bankers’ group, wrote in his letter to regulators, "that many of the loan products and characteristics under consideration to be restricted were, for many years, not problematic when underwritten prudently."
Wake up, Americans. Your economic dream is a nightmare
by Jeffrey Simpson - Globe and Mail
Our southern friends are living the American dream these days, a dream that’s removing them from reality. Their federal legislators, including the President, are imagining a brilliant future that cannot be. None of them, it would appear, wants to awaken Americans from this dream.
The dream? Economic recovery followed by the return of prosperity, built on borrowed money. And not just some borrowed money, but trillions and trillions of borrowed money. In this scenario, the rest of the world will keep lending to the United States, borrowing costs won’t rise, inflation will be banished, and the punishment that would befall almost any other country that ran such a lopsided budget will not strike the U.S.
Like all dreams, this one has lost touch with reality. In Washington, legislators seem to accept that amassing trillions of dollars of additional debt is a bad idea. Then they argue furiously about a mere 12 per cent of the budget that, even if half of it were to be eliminated, would still leave the government in a deficit position this year. The discretionary part of the budget contains programs people count on, everything from education to the environment, food inspections to basic research, farm aid and student assistance. The other parts of the budget are debt, the military and the so-called entitlement social programs of health care for the poor and seniors and social security.
Two bipartisan non-governmental commissions have instructed the country in simple arithmetic: namely, that the budget can’t be restored to sanity without cuts to discretionary spending and entitlement programs, and tax increases. In the dreamland of U.S. discourse, however, no one wants to talk about cuts to entitlement programs or tax increases. Worse, just before Christmas, Congress and the President forged a deal that continued the fiscally ruinous tax cuts of George W. Bush, the ones so tilted toward the already wealthy, and pumped even more discretionary spending into the U.S. economy.
American friends who despair of dreamland discourse acknowledge that it will take a "crisis" to awaken enough people so serious action can occur, instead of the shadowboxing that passes for action. What would constitute a "crisis"? The stock market is roaring; happy days have returned to Wall Street financiers. Interest rates are low. True, the unemployment rate is above 9 per cent, but that means 91 per cent of Americans are working.
Would a huge run on the dollar be a "crisis"? Would a serious surge in inflation? Or a nose-diving stock market? Or another housing plunge? Or all of the above? No one wants any of the above, but what will it take to awaken Americans from their dream? It might have been thought that their President would try to alert them to the damage being done daily to their future, and to the serious shift in world power and influence away from a country so hobbling itself with debt.
Barack Obama has obviously calculated that the political risks are too great for candour, so he, too, operates within the dream by proposing some restraint on discretionary spending without touching the entitlement programs, the military or taxes. In this, he is complicit with Republicans in deforming the nature of the debate and ill-informing Americans. He has obviously reckoned that, with the Republicans believing the problem can be solved by discretionary spending cuts alone, he isn’t going to do anything credible before the next election.
So health care for seniors and the poor continues to rise by 8 per cent annually. The bloated Pentagon budget will be a staggering $670-billion. Still, the Secretary of Defence says any cut of more than $9-billion would cripple the nation’s capacity to defend itself. With a 5-per-cent national sales tax, of the kind every other industrial country has implemented, the U.S. would be halfway home to budgetary solvency. In dreamland, however, such a dose of reality is unthinkable.
Worse Than You Ever Dreamed
by Alan Abelson - Barron’s
By any yardstick, last week measures up as chock full of exciting events. The Middle East continued to erupt in a half-dozen or so places. Iran decided it would like to take a look at the Suez Canal, so it sent a couple of warships to Syria via the canal, and Israel—who would have guessed?—didn't cotton to the idea. Egypt revived in a somewhat different context the old Abbott and Costello routine about who's on first (just leave out the "on").
President Obama unveiled his budget proposal, which drew tepid cheers from Democrats and screaming derision from knife-wielding Republicans, a splendid example of bipartisanship in action. Colorado banned welfare cards at strip clubs, which holds grave implications for naked shorts, one of Wall Street's favorite illicit sports. New York City found $2 billion it didn't know it had—somebody must have put it back.
Ben Bernanke flew off to Paris for a meeting of the Gang of 20 as much as anything to get away from his congressional tormentors, not a few of whom are after his scalp (they better hurry, the poor guy seems to be losing his hair fast). But wouldn't you know, no sooner did he set foot in Gay Paree than he was scolded by the gaggle of mucky-mucks from other nations in the G-20 about our nation's feckless financial ways. They couldn't wait to queue up to voice their complaint about QE1 and QE2 serving as a covert devaluation of the precious greenback.
Lest we give you the impression the week was filled with cacophony and uprisings and that sort of unsettling stuff, there were some quite positive happenings as well. We discovered that all the talk of America's decline, as evidenced in the apparent end of the nation's technological superiority, is just so bunk. What opened our eyes to that bracing insight was a brochure we received from a company describing its ground-breaking invention: a video tombstone starring the deceased. It enables the viewer to see and hear him as he actually was while still alive. Literally—a voice from the grave and a face to go with it.
We've been saving the best for last: Equities extended their gaudy winning streak, blithely ignoring such trivia as disappointing retail sales and intimations that inflation's demise has been greatly exaggerated. This has been the most resilient market we've ever had the pleasure of witnessing. Enjoy it, by all means, as long as it lasts. You won't lack for company, as pros and the public are piling in, but keep in mind that an excess of bullishness, as manifestly exists today, has been know to lead to a fall.
Please don't tell Wikileaks, if only because they don't know how to keep a secret. It concerns housing. Everyone knows, of course, that it's in the pits. Considerably less well known is just how deep those pits really are. Which explains our squeamishness about the news getting around, as it might temper—and we stress might—the irrational exuberance (the pithy phrase may be Alan Greenspan's most enduring legacy from his many years running the Fed) that has rocketed the stock market to 32-month highs and climbing.
Conceivably, the revelation we're about to share with you could put at least a temporary pall over hopes for the long-awaited and often prematurely heralded housing recovery, and the very last thing we want to do is make investors or plain old civilians unhappy. For most people, their house, be it ever so humble, is their largest single investment. (And all these years we've been suffering under the delusion that a house was, pure and simple, to live in. It came to wear an "investment" label during the wild years of the last decade, when it was viewed as an ATM and an asset that could only appreciate in value.)
As Stephanie Pomboy in her always lively MacroMavens dispatch points out, the acrid aftermath of the big bust in housing has failed to dissipate and adamantly hangs on. The average homeowner with a mortgage, she notes, has a scant 2.6% equity in his house, and the already towering delinquency and foreclosure rates seem headed for a new thrust upward, with interest rates creeping up and jobs remaining anything but easy to come by.
Hardly surprising, then, that demand for mortgages has sagged to a 27-month low, an evil omen for something even vaguely resembling a decent recovery in housing.
What's more, if CoreLogic is right, things are a heck of a lot worse than most of us dreamed. CoreLogic, in case you wondered, is a demon data collector of, among other things, property and mortgage info that it peddles to business and Uncle Sam. Last week, it released a report that expresses grave doubts as to the accuracy of the widely followed calculations of home sales and other critical items by the National Association of Realtors, claiming they are seriously flawed, tending to understate the bad news, while inflating not-so-bad by 15% to 20%.
By way of example, according to the Realtors' reckoning, existing-home sales last year declined 5%, to 4.9 million. By CoreLogic's count, however, existing-home sales totaled a meager 3.6 million, a drop of 12% from the '09 total. The disparity between the two is also graphically evident in their respective gauges of the size of the inventory of unsold houses. The Realtors figure the overhang is around nine months worth of supply, but CoreLogic counts the visible inventory of homes with a "for sale" out in the front yard at 16 months. Normal is six or seven months.
CoreLogic suggests the wide spread between itself and the Realtors is possibly explained by the difference in how the two gather the data and by out-of-date benchmarks (which the Realtors say they aim to recalibrate). The Realtors canvass multiple listing services and large brokerages. CoreLogic compiles its data from publicly available records stored in courthouses. Historically, CoreLogic adds, its survey pretty much agreed with 85% to 90% of the Realtors' count, but began to diverge in earnest about 2006, when the housing market was smoking.
Home prices, meanwhile, have been caught in another downward spiral, reflecting a lack of demand and a huge supply, the bitter fruit of the great bust that followed the wild and woolly boom and a prime victim of the jobless recovery in the economy at large. If current trends persist, those already sharply lower prices, CoreLogic predicts, by spring will be down more than 10% from last year's comparable stretch.
It's too early, perhaps years too early, to sound the all-clear for housing and obviously, the bedraggled home builders. So far as we know, there never has been a vibrant economy that was saddled with the housing sector in extremis. Maybe this is the one time it's different. But don't bet on it.
One big winner in the fierce rally of the last five months or so has been the chip companies. A peek at the chart of the Philadelphia Semiconductor Index shows an almost perpendicular rise, from around 300 in September to around 470 last we looked. Sparking this brisk run, you won't be shocked to learn, is the flood of new electronic gadgets—smartphones, tablets and a whole roster of new and (to some people, exciting) products, all of which translate into demand for chips.
In his latest edition of the High-Tech Strategist, Fred Hickey, whose presence also graces the Roundtable, has some kind words for Intel, No. 1 in semiconductors. The company, he notes, reported a bang-up fourth quarter and strong guidance for the present three months.
Like Microsoft, he goes on, the stock remains unloved for reasons beyond his ken. Intel shares are selling at only 10.5 times earnings; the company has boosted its dividend and plans to increase its share-buyback program by $10 billion and this year's capital spending by a whopping $9 billion. As Fred drily remarks, "These are not actions typically taken by a management worried about its future." He takes care to separate the wheat from the chaff among the chip companies. He also alludes to a surplus of inventory built up last year.
A research study released last week by IHS iSuppli, which specializes in tech services, warns swollen chip inventories could prove a problem. Global stocks of chips held by suppliers, it estimates, were at their highest level since the second quarter of 2008—just before the chip makers took gas. IHS reckons semiconductor revenue growth of 5.6% in 2011, down sharply from last year's 31.8%, but thinks that if growth actually comes in as forecast, "the current inventory level should be manageable." Strikes us as an ambiguous attempt at reassurance, since it is unclear what "manageable" connotes.
Much less equivocal is what IHS sees as the consequences if growth is less than predicted. Then, those bloated inventories become a headache, are dumped on the market, causing chip prices to tumble faster than usual. This could "amplify the size and duration" of a downturn or even a significant slowdown in semiconductors.
Won't be great for their stocks, either.
Money Won’t Buy You Health Insurance
by Donna Dubinsky - New York Times
This isn’t the story of a poor family with a mother who has a dreadful disease that bankrupts them, or with a child who has to go without vital medicines. Unlike many others, my family can afford medical care, with or without insurance. Instead, this is a story about how broken the market for health insurance is, even for those who are healthy and who are willing and able to pay for it.
Most employees assume that if they lose their job and the health coverage that comes along with it, they’ll be able to purchase insurance somewhere. The members of Congress who want to repeal the provision of last year’s health insurance law that makes it easier for individuals to buy coverage must assume that uninsured people do not want to buy it, or are just too cheap or too poor to do so.
The truth is that individual health insurance is not easy to get.
I found this out the hard way. Six years ago, my company was acquired. Since my husband had retired a few years earlier, we found ourselves without an employer and thus without health insurance. My husband, teenage daughter and I were all active and healthy, and I naïvely thought getting health insurance would be simple.
Why did we even need insurance? First, we wanted to know that, if we had a medical catastrophe, we would not exhaust our savings. Second, uninsured patients are billed more than the rates that insurers negotiate with doctors and hospitals, and we wanted to pay those lower rates. The difference is significant: my recent M.R.I. cost $1,300 at the "retail" rate, while the rate negotiated by the insurance company was $700.
An insurance broker helped me sort through the options. I settled on a high-deductible plan, and filled out the long application. I diligently listed the various minor complaints for which we had been seen over the years, knowing that these might turn up later and be a basis for revoking coverage if they were not disclosed. Then the first letter arrived — denied. It never occurred to me that we would be denied! Yes, we had listed a bunch of minor ailments, but nothing serious. No cancer, no chronic diseases like asthma or diabetes, no hospital stays.
Why were we denied? What were these pre-existing conditions that put us into high-risk categories? For me, it was a corn on my toe for which my podiatrist had recommended an in-office procedure. My daughter was denied because she takes regular medication for a common teenage issue. My husband was denied because his ophthalmologist had identified a slow-growing cataract. Basically, if there is any possible procedure in your future, insurers will deny you.
The broker then proposed that the three of us make individual applications. Perhaps one or two of us might be accepted, rather than the family as a group. As I filled out more applications, I discovered a critical error in my strategy. The first question was "Have you ever been denied health insurance"? Now my answer was yes, giving the new companies reason to be wary of my application. I learned too late that the best tactic is to apply simultaneously to as many companies as possible, so that you don’t have to admit to a denial.
I completed four applications for each of the three of us, using reams of paper. I learned to read the questions carefully. I mulled over the difference between a "condition" and "something for which you have sought treatment." I was precise and succinct. I felt as if I was doing a deposition: Give the minimum true information, and not a word more. I was accepted by exactly one insurance company. So was my daughter, although at a 50 percent premium over the standard charge for a girl her age. My husband was also accepted by one insurer but was denied by the company that approved me.
Our premiums, which were reasonable at first, have increased substantially over the last six years; the average annual increase has been 20 percent. I now am paying premiums that are more than double what they were initially. And because these are high-deductible policies, we still are paying most of the medical bills ourselves.
The new health care reform legislation is not perfect. Nothing that complex could be. But I have no doubt that the system is broken and reform is absolutely essential. If we are not going to have universal coverage but are going to rely on employer plans, then we must offer individuals, self-employed people and small businesses a place to purchase insurance at a reasonable price.
If members of Congress feel so strongly about undoing this important legislation, perhaps we should stop providing them with health insurance. Let’s credit their pay for the amount that has been paid by the taxpayers, and let them try to buy health insurance in the individual market. My bet is that they all would be denied. Health insurance reform might suddenly not seem to them like such a bad idea.
Donna Dubinsky, a co-founder of Palm Computer and Handspring, is the chief executive of a computer software company.
The Perils of Inequality
by Mark Whitehouse - Wall Street Journal
364% — Difference in the hourly earnings of high-paid and low-paid employees.
US consumers are in a much better financial situation than they were just a couple years ago. But the poor and middle class still have at least one big incentive to get into trouble again: The growing challenge of catching up to the rich.
Various economists, most notably Raghuram Rajan of the University of Chicago, have stressed the pivotal role income inequality played in the financial crisis. Poorer Americans’ debt troubles, the logic goes, stemmed in part from their efforts to bridge the gap with the rich by borrowing money. A flood of cash from China, together with enterprising bankers and mortgage subsidies from the U.S. government, created the perfect environment for those efforts to get out of control.
Now U.S. consumers have managed to shed a lot of their debt. They’ve done so at great cost to the economy, which has swallowed hundreds of billions of dollars in bad loans. As of September 2010, total household debt stood at 118% of disposable income, down from a peak of 130% three years earlier. Much of that has shifted to the government, which has seen its debt to the public rise to 61% of GDP, from 36%, over the same period.
The inequality, though, hasn’t gone away. Rather, it’s hitting new records. As the economy bottomed out in 2009, the hourly wage of employees in the 90th pay percentile—those whose wage exceeded that of 90% of the working population—stood at $38.50, according to a new study by the Congressional Budget Office. That’s 364% more than the $8.30 an hour earned by those in the 10th percentile. A decade earlier, the difference was 332%, adjusted for inflation. The difference is more pronounced for men than women, at 383% versus 319%.
The growing gap partly reflects the effects of globalization and technological change, which help highly educated workers get more for their skills. But inequality causes a lot of problems: It can contribute to political polarization, and it raises the stakes for less wealthy consumers who want to keep the American dream alive.
To be sure, it’s not as easy to get into debt trouble as it was before the crisis. Banks are more careful, and subprime lending has all but disappeared (with the notable exception of the booming junk-bond market). But the Federal Reserve is trying as hard as it can to get people borrowing again. And in some areas, people are beginning to rack up debt: In the last three months of 2010, credit-card balances rose at an annualized rate of 2.7%, the highest since mid-2008. As of December, margin debt in the stock market was also at its highest level since mid-2008.
Let’s hope recent history doesn’t repeat itself.
Danger is Pent Up Behind Aging Dams
by Henry Fountain - New York Times
Frank Brassell, owner of Nelda’s Diner in this town wedged between the slopes of the southern Sierra Nevada, knows his fate should Lake Isabella Dam, a mile up the road, suddenly fail when the lake is full. "I work here," Mr. Brassell said, looking around the brightly lighted diner. "And I live right over there," he added, pointing across the town’s main street. "The water would all come down here and it would try to take a right turn and go under the freeway, and it wouldn’t all go," he said. "So I’m dead."
Lake Isabella Dam is just one acute example of a widespread problem: Of the nation’s 85,000 dams, more than 4,400 are considered susceptible to failure, according to the Association of State Dam Safety Officials. But repairing all those dams would cost billions of dollars, and it is far from clear who would provide all the money in a recessionary era. The stakes are particularly high not just for Mr. Brassell and the other 4,000 residents of Lake Isabella, but for the 340,000 people who live in Bakersfield, 40 miles down the Kern River Canyon on the edge of California’s vast agricultural heartland.
The Army Corps of Engineers, which built and operates the 57-year-old dam, learned several years ago that it had three serious problems: it was in danger of eroding internally; water could flow over its top in the most extreme flood season; and a fault underneath it was not inactive after all but could produce a strong earthquake. In a worst case, a catastrophic failure could send as much as 180 billion gallons of water — along with mud, boulders, trees and other debris, including, presumably, the ruins of Nelda’s Diner — churning down the canyon and into Bakersfield. The floodwaters would turn the downtown and residential neighborhoods into a lake up to 30 feet deep and spread to industrial and agricultural areas.
The potential is for a 21st-century version of the Johnstown Flood, a calamitous dam failure that killed more than 2,200 people in western Pennsylvania in 1889. But corps and local government officials say that the odds of such a disaster are extremely small, and that they have taken interim steps to reduce the risk, like preparing evacuation plans and limiting how much water can be stored behind the dam to less than two-thirds of the maximum.
Still, they acknowledge that the impact of a dam failure would be enormous. "It’s not just the loss of life, potentially," said David C. Serafini, lead technical expert for the corps on the project. "It’s the economic damages and the environmental damage, too." Corps engineers are preparing to propose fixes later this year. But at best, repairs would not begin until 2014 and could cost $500 million or more, money that would have to be approved by Congress.
Nationwide, the potential repair costs are staggering. A 2009 report by the state dam safety officials’ group put the cost of fixing the most critical dams — where failure could cause loss of life — at $16 billion over 12 years, with the total cost of rehabilitating all dams at $51 billion. But those figures do not include Lake Isabella and other dams among the approximately 3,000 that are owned by the federal government. The corps, for example, says that more than 300 of the roughly 700 dams it is responsible for need safety-related repairs, and estimates the total fix-up bill at about $20 billion.
The corps has already spent about $24 million just to determine the scope of the problems at Lake Isabella, and with the New Orleans levee failures during Hurricane Katrina a lingering memory, Congress has appropriated money for other federal dam repair projects as well.
But about two-thirds of all dams are private, and financially struggling state and local governments own most of the remainder. It is difficult to predict how needed repairs to these dams will be financed; legislation to provide federal money to help has languished in Congress. What’s more, the number of high-risk dams keeps rising as structures age, downstream development increases and more accurate information is obtained about watersheds and earthquake hazards.
Among the corps’s dams, Lake Isabella is one of 12 that are ranked in the highest category, as a dam with serious problems and serious failure consequences, given the large downstream population. "The classification is it’s an unsafe dam," said Eric C. Halpin, the corps’s special assistant for dam and levee safety. But Mr. Halpin noted that 319 of the corps’s dams were considered "actionable from a safety standpoint."
Lake Isabella would be one of the more expensive projects, but then again, its problems are legion. It is actually two earthen dams, a main one that is 185 feet high and an auxiliary one that sits on higher ground and is 100 feet high. With a rock ridge between them, they stretch for about a mile across the Kern River Valley. For six decades the dams have controlled flooding on the Kern, helping Bakersfield to grow and thrive. And the lake that formed behind the dam has become the main driver of the economy of Lake Isabella and other towns, bringing fishers, boaters and whitewater rafters to the area.
But there have always been people in the area who felt the dams were flawed. David Laughing Horse Robinson, an artist and teacher who lives in the lakeside town of Kernville, said his grandfather, who worked on the dam, and others used to talk about it. "Constantly," he said. "How it was the stupidest thing they ever did. It’s doomed." Water seeps through the Lake Isabella dams, as it does through most earthen dams, which account for a vast majority of dams in the United States. But the seepage at Lake Isabella was especially severe — it is what prompted the corps to perform a full-scale study of the dam.
Water seeping through a dam can erode it from the inside out, to the point where the dam may fail. Engineers have learned to build structures into dams like drains and filters, to stop erosion and allow infiltrating water to drain safely away. But the Lake Isabella dams were constructed before such features became commonplace. "It was built with the best available knowledge and technology at the time," said Veronica V. Petrovsky, who is managing the project for the corps.
That knowledge, or lack of it, extended to the understanding of the large and complex watershed, which includes the slopes of Mount Whitney, the tallest peak in the contiguous United States. To determine how big the spillway needs to be, it is critical to know how much water might be impounded behind the dam each year. Calculations show that in an extreme year with a "probable maximum flood," the spillway would be far too small. "We could not release the water fast enough," Ms. Petrovsky said. "It would overtop." An overtopped dam can fail quickly as the water erodes the downstream side.
Concerns about seepage, in particular, prompted the corps to restrict the lake level, because less water creates less hydrostatic pressure that would force water through the dam. Earlier this winter, the lake was so low that water did not even lap up against the auxiliary dam. But the corps has been monitoring the heavy rains and snowfall that California has experienced this winter and says that in the spring and summer it may be necessary to divert water through the spillway to maintain the safer lake level. Overtopping, however, presents only a "small concern," the corps said.
With both seepage and overtopping there would be plenty of warning that the dam was in jeopardy, allowing Lake Isabella and Bakersfield residents to evacuate. An earthquake would be a more immediate disaster, although Bakersfield would still have about seven hours before a wall of water made its way down the canyon, according to the corps. The auxiliary dam was built, knowingly, on the Kern Canyon fault, one of many in the region. At the time the corps brought in seismologists and geologists who concluded that the fault was not active.
Only recently have scientists been able to accurately detect and measure ancient earthquakes, a field known as paleoseismology. Mr. Serafini and others determined that there have been three significant earthquakes on the fault in the past 10,000 years. "We have got a fairly active fault on our hands," Mr. Serafini said. The last quake occurred about 3,400 years ago, he added.
It’s possible to construct a safe earthen dam on an active earthquake fault, by using the proper materials to minimize settlement or slumping when shaken, and including drains and filters to help stop the inevitable cracks from growing through erosion. Not only do the Lake Isabella dams lack those features, but the auxiliary dam was built on sediments that could turn into a virtual liquid in a quake, leading to even greater damage.
While Mr. Serafini and his team are still working on proposals, the likeliest solutions include blasting a much bigger spillway out of bedrock adjacent to the main dam and using the excavated rock to build a buttress — essentially an entirely new dam — downstream from the auxiliary dam. The old dam could still move in an earthquake, Mr. Serafini said, but the buttress would have the necessary drains and filters to prevent failure.
While the proposals are being fleshed out, the corps team has been holding meetings in the area to let people know what the possibilities are. "We don’t hear much from the people of Bakersfield," Ms. Petrovsky said. "It’s one of those ‘out of sight, out of mind’ things. You forget there’s a dam up here holding back a lot of water."
Not so in Lake Isabella, however, where the dam, and its potential for failure, are harder to ignore. "I think we’ve all put some thought into it," said Mr. Brassell, the diner owner. "But anytime you have a diverse group of people there are going to be those who are panicked at some level, and those who are calm. Faith in God, you know. He’s going to do what he wants."